401(k) Tips

Who qualifies for CARES act 401k withdrawal?

If you are experiencing financial hardship due to COVID-19, you may consider making a 401(k) withdrawal to ease your burden. Find out if you qualify for CARES Act 401(k) withdrawals.

3 min read

As the COVID-19 caused havoc on the world economy, Congress passed the CARES Act to ease the burden of American workers who experienced financial hardships due to the pandemic. If you got laid off, got a pay cut, or closed your business during the pandemic, you could consider taking a 401(k) withdrawal. However, only qualified participants can take these withdrawals.

You can take a CARES Act 401(k) withdrawal if you, your spouse, or your dependents have been diagnosed with COVID-19. You can also take a COVID-19 withdrawal if you experienced adverse financial consequences such as layoffs, reduced working hours, or business closure due to COVID-19. If you qualify, you will be allowed to take penalty-free distributions from 401(k) even if you are below 59 ½. 

What is a 401(k) CARES Act Withdrawal?

In normal circumstances, withdrawals from a tax-deferred 401(k) before age 59 ½ attract a 10% penalty, in addition to income taxes on the distribution. A 401(k) plan is set up to allow distributions from age 59 ½, and early withdrawals before this age attract a penalty.

If you have an immediate financial need such as medical expenses and home repairs after a disaster, you may be allowed to take a hardship withdrawal. You may also qualify for an exemption on the 10% penalty for early withdrawals. However, you can only withdraw up to the specific amount you need to satisfy your financial need.

Under the CARES Act, you can withdraw funds from your 401(k) to meet the hardships caused by the COVID pandemic. The IRS eliminates the 10% penalty for early withdrawals, and you can withdraw up to $100,000 penalty-free.

If you withdraw an amount that exceeds the $100,000 limit, you will pay a 10% penalty tax on the excess amount if you are below 59 ½.

Who qualifies for Care act 401(k) withdrawals?

Not every 401(k) owner benefits from the CARE's Act relaxed rules for early distributions. You may qualify for a tax penalty exemption if you meet these requirements:

  • The account owner, their spouse, or dependent is diagnosed with COVID-19
  • The account owner experienced a layoff, reduction in working hours, furlough, or inability to engage in productive activities due to COVID-19.
  • The account owner has a rescinded job offer or job start date delayed due to COVID-19.
  • The account owner experienced adverse financial consequences due to their individual finances or spouse’s finances being affected by COVID-19.
  • The account owner’s business closed down or reduced working hours due to COVID-19. 

If you meet one or more of these requirements, you will be required to prove that you were affected by COVID-19, either directly or indirectly, to benefit from the CARES Act relief. Also, the CARES Act is not a mandatory provision, and some retirement plans may decide not to allow COVID-19 related hardship withdrawals.

How CARES Act 401(k) Withdrawals Work

Before you can request a COVID-19-related distribution, you should speak with the plan administrator to know if it allows these distributions. Usually, if the 401(k) plan accepts COVID-19 hardship withdrawals, you will need to complete a withdrawal form, detailing the hardship you are experiencing.

The withdrawal request should be sent to the retirement plan for review. If your withdrawal meets the IRS requirements for COVID-19 withdrawals, the plan will start processing the withdrawal, and it can take several days or weeks for funds to be disbursed.

If you fail to prove the nature of hardship you are experiencing, the 401(k) plan will reject the hardship withdrawal. However, you may be allowed to take a 401(k) loan to meet the financial needs you have. You can borrow up to 50% of your vested balance, up to a maximum of $50,000.

CARES Act 401(k) loan rules

Standard 401(k) rules allow 401(k) participants to borrow up to $50,000 or half of their vested balance. You will then be required to pay off the loan over a period of five years, and the loan payments will be paid back to the 401(k) account.

The CARES Act increases the amount you can borrow from your 401(k) to 100% of your vested account balance or a maximum of $100,000. The increased loan limit was available for loans taken within the six months from March to September 2020. The 401(k) loan must be fully paid in five years.

The CARES Act offered a one-year loan relief in 2020, and borrowers were required to start loan payments in 2021.

How COVID 401(k) withdrawals affect your taxes

The CARES Act allowed 401(k) owners to withdraw up to $100,000 from their retirement account penalty-free, even if they are younger than 59 ½ at the time of withdrawal. However, they are still required to pay income taxes on the distributions.

While the IRS requires retirement savers to pay taxes in the year of distribution, the CARES Act allows retirement savers to stretch the taxes owed on the distribution over a three-year period. For example, if you took a COVID-related distribution of $30,000 in 2020, you can stretch this income over the next three years i.e. 2020, 2021, and 2022. You can also opt to pay the full taxes owed either in 2020, 2021, or 2022, as long as all the taxes are paid by the third year.

If you want to avoid paying income taxes on the COVID-related distributions, you can return the distributions taken back to the 401(k) within three years. If you have already paid income taxes on the distribution, and then pay back the money in the 401(k), you can file an amended tax return and get a tax refund.