Is There a Cure for Covid Caused 401k Leakage?

Is There a Cure for Covid Caused 401k Leakage?

September 19, 2023

Check out my contribution to an article published in Fiduciary News...

Is There a Cure for Covid Caused 401k Leakage?
by Christopher Carosa September 19, 2023

It seemed like a good idea at the time. But, then, there were a lot of things that seemed like a good idea at the time. Especially when the particular time in question features a never before experience event.

Such was the time of Covid. So many unknowns. So many worries. So many quick answers before all the data could be reviewed.

Does that sound like the making of a disaster? It could be. The road of good intention is so paved. Indeed, the failure to act during a previous crisis can grease the wheels in the next crisis.

“In 2008 many 401k participants experienced penalties in addition to the large losses in value,” says Richard Bavetz, investment advisor at Federal Retirement Consultant, Carington Financial in Westlake Village California. “As millions faced job losses, reduced hours, or unexpected medical bills due to Covid, the relaxed regulations on retirement plan withdrawals provided an immediate source of funds to cover essential expenses.”

When Covid hit, anxiety levels soared, not only for one’s physical health but for one’s fiscal health as well. There was a demand for action, action of any kind.

“During the pandemic, the CARES Act provided qualified individuals (such as those who experienced adverse financial consequences related to their own Covid-19 diagnoses, or that of their spouse or dependents) with expanded distribution options and favorable tax treatment for up to $100,000 of coronavirus-related distributions from eligible retirement plans,” says Michelle Capezza, Of Counsel at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. in New York City. “The CARES Act also permitted adjusted plan loan limits to the lesser of 100% of the vested balance or up to $100,000. Beyond the pandemic, the SECURE 2.0 Act has also made permanent the ability to obtain qualified disaster distributions related to federally declared disasters, as well as other emergency type distributions. These, and other, opportunities to obtain plan distributions for certain qualifying events can be helpful to plan participants in their time of need and may serve to encourage individuals to save in such plans if they can feel comfortable that they can obtain access to these monies without penalty for certain qualifying events.”

In response to Covid, these laws were passed, and attendant regulations were promulgated to make it easier for people to take premature withdrawals from their retirement plans. How did these moves help people?

“Depends on what your definition of ‘help’ is,” says Lawrence (Larry) Starr, VP at Cornerstone Retirement/QPC in West Springfield, Massachusetts. “If you take it out today, you don’t have it for retirement later. For those who used this, it helped them have less money at retirement.”

Specifically, though, what went sour? How did this government action take the wrong approach?

“It provided liquidity—but the wrong form of liquidity,” says Jack Towarnicky, Of Counsel, Koehler Fitzgerald, LLC in Powell, Ohio. “Only a small minority who took distributions repaid those distributions. The right kind of liquidity would have been to update plan loan processing to 21st Century functionality and capability.”

It’s clear, then, that there’s a problem. In order to best come up with a cure for Covid-related leakage, we have to zero in on exactly when the trouble lies.

“While these provisions did provide immediate relief, penalty exemptions created a path of least resistance for many people making it too easy to spend money from retirement accounts, rather than looking for better alternatives,” says Bavetz. “Robbing these accounts not only reduces the funds available in retirement but also sacrifices potential future earnings on those funds. Because retirement accounts are already lower than previous generations, participants are already behind in their retirement savings. This will ultimately create long-term effects.”

Part of the solution already exists. It’s laid out in the original rules.

“While it can be helpful to have access to retirement savings for certain qualifying events, it can also adversely impact achievement of retirement savings goals,” says Capezza. “With the coronavirus-related distributions, for example, they could be repaid in full or in part to an eligible retirement plan within three years after the date that the distribution was received so that the individual would not owe federal income tax on the distribution. If an individual repaid the full amount back in 2022, they could file an amended tax return for 2020 and 2021 to claim a refund of the tax attributed to the amount of the distribution that was included in income in those years. However, not everyone will repay the distribution and they might not even be aware that they could, thus losing out long term on having these monies for retirement. This is a prime example of why employee communications are so important to explain how retirement plan provisions work and to encourage that they be utilized optimally to preserve retirement savings. It is also important for plan sponsors to consider their overall plan designs and whether adding layers of optional plan distribution features will serve to benefit their plan populations in the long term.”

In the end, the surest way to success is to upgrade how plan loans are structured.

“Plan loans are not leakage unless they are not repaid. 90+% of plan loans are repaid,” says Towarnicky. “Almost all loans that default and become leakage are the result of the service provider’s failure to update their loan processing to 21st Century functionality and capability—which would not only allow individuals to keep paying loans after separation but would allow the term vested/retired participant to initiate a loan after separation. Similarly, 21st Century functionality includes service provider accommodation of outstanding plan loans (within the extended time frame for repayment)—enabling ‘rollover’ of the outstanding plan loan into a subsequent employer’s plan via a rollover of the residual balance.”

Adopting these methods will go a long way towards curing loan leakage, whether it’s because of Covid or other hardships.

Christopher Carosa is an award-winning online news producer and journalist. A dynamic speaker, he’s the author of 401(k) Fiduciary Solutions, Hey! What’s My Number? How to Improve the Odds You Will Retire in Comfort, From Cradle to Retirement: The Child IRA, and several other books.