CARES Act: 403(b)/457(b) Escape Hatch - A Potential $500K Fee Savings Strategy
An Escape Hatch From Your Costly 403(b) or 457(b)
The Covid-19 pandemic has created an opportunity for teachers (and school employees) to potentially lower the costs in their 403(b) and 457(b) by significant margins, this escape hatch will only work in 2020. While we welcome the opportunity, we wish it didn’t take a pandemic and we would trade this opportunity in a split-second to have not ever have heard the term coronavirus.
Coronavirus Related Distributions
What I’m referring to is a provision of the CARES Act that allows certain individuals who have been affected by COVID-19 to withdraw up to $100,000 from their IRA, 403(b), 457(b) or 401(k) without paying the normal 10% federal penalty if under the age of 59 1/2. In addition, there are no mandatory withholdings for defined contribution plans and the withdrawal can be paid back for up to three years with taxes being spread over three years.
The key to this strategy is that he distribution can be paid back to any “eligible retirement plan”, not just the account it came from. An eligible retirement plan is defined in section 402(c)(8)(B) and includes 403(b), 401(k), 457(b) and IRAs.
The Significance to Teachers
The effect of this new law is that in 2020 a teacher can make a qualified distribution from their high-cost 403(b) and then subsequently repay that distribution to a low-cost IRA, potentially savings hundreds of thousands of dollars in fees over their lifetime. This provision represents a huge opportunity for teachers who have been stuck in expensive, poorly run 403(b) programs.
A 45 year old implementing this strategy with a moderate risk portfolio could save over $500,000 in fees over their lifetime if they lived to 100, over $350,000 living to age 85. These are astounding figures (and they underestimate the potential fee savings).
Is It Really That Simple?
Yes and no. The strategy is completely legal and rather straight forward, but whether one qualifies for the distribution is the key, and as of early April, there is still some ambiguity.
You must meet certain distribution qualifications set forth as follows:
1. You or your spouse must have been diagnosed with (COVID-19) by a test approved by the Centers for Disease Control and Prevention, or
2. You must have experienced adverse financial consequences as a result of: being quarantined, being furloughed or laid off or having work hours reduced due to such virus or disease, being unable to work due to lack of child care due to such virus or disease, closing or reducing hours of a business owned or operated by the individual due to such virus or disease, or other factors as determined by the Secretary of the Treasury (or the Secretary’s delegate).
While the law allows you to self-certify to the above, you do need to fall into one of these categories and proof could be requested at a later date, presumably from the IRS. With that said, the term “adverse financial consequences” is a pretty broad term. The law anticipates that your financial condition might change, hence the ability to repay the distribution for up to three years.
My biggest concern is how the term quarantine will be defined by the IRS. There has been no word from Treasury as to how they view the term and most laypeople would define it broadly. Given participants are allowed to self-certify, it seems reasonable that they can rely on a layperson’s understanding of quarantine. Most people consider being required to “shelter in place” or “shelter at home” to effectively be a quarantine even though it might not meet the technical definition (of which there is none yet in regards to this law).
The question remains what the penalty would be for taking a distribution that is later deemed not qualified. Would the penalty only apply for monies NOT returned to an eligible retirement plan? If yes, there is no risk, but we don’t yet know the answer to this question. To be safe, if you decide to pursue this strategy, you need to actually meet the distribution qualifications and be able to prove it.
Given that the government doesn’t lose a penny of tax revenue in this transaction even if one in retrospect doesn’t qualify, it would seem odd to me that the IRS would crack down on people using this strategy. However, I cannot predict how the IRS will operate a year from now and you should seek the advice of your CPA or tax preparer.
Amendments Not Automatic
It turns out that COVID-19 related distributions are an optional plan feature, meaning your employer does not have to adopt them, however the plan doesn’t need to immediately amend their plan document, according to employee benefits legal firm Holland and Knight:
“Changes can be implemented and become effective immediately, but will not need to be adopted as an amendment to the applicable plan document until on or before the last day of the first plan year that begins on or after Jan. 1, 2022. Governmental plans have an additional two years to adopt amendments.”
Your school employer has until 2024 to amend their documents. A number of compliance administrators have already pushed out these amendments via “negative consent”, meaning they will be automatically adopted unless the employer objects. While a few have objected, the vast majority seem to be allowing such amendments.
How To Escape From Your Bad 403(b)
With the technicals out of the way, let’s now dig into how to trigger your escape hatch.
This will require paperwork, some of which might not yet be available, though my anecdotal research is showing it should be ready with most vendors now or very soon.
You will need a distribution form from your current vendor and a transaction request form from your compliance administrator. You will be requesting a “coronavirus-related distribution”. This is NOT a hardship withdrawal, it’s very important that this is labeled as a “coronavirus-related distribution.”
You will submit the transaction request form and the distribution form to your compliance administrator who will approve and send on to your current 403(b) or 457(b) vendor. The vendor should process and send you a check for up to $100,000 which you will deposit to your bank account, not another retirement plan. Remember, this money is a distribution related to experiences of adverse financial consequence, if you quickly deposit the money to another retirement account it’s an indication you didn’t need the money in the first place.
Once you have determined that the money will not be needed and you feel safe to deposit that money back into a retirement plan, you will need to open an IRA at your favorite mutual fund or brokerage company. Once this account is opened you will “repay” the distribution to that account (technically it will be coded as a trustee-to-trustee transfer).
There you have it, up to $100,000 per individual rescued from a high-cost 403(b) or 457(b).
Items to Consider
This is a taxable distribution. While you have the ability to repay this money back to an eligible retirement plan within three years, you must actually do so in order to avoid paying the taxes owed. If you do so in 2020, you will have no tax issues. If you wait till 2021 or later, you will have to pay taxes over the tax years 2020, 2021 and 2022 unless you elect to pay it all in 2020.
You will be out of the market for at least a week, potentially longer. The 403(b) world is a mess. Transactions in good times take weeks, sometimes months to occur and with the ongoing volatility in the stock market you could be out of it for several weeks and miss out on gains (of course the opposite is true). This needs to be taken very seriously.
Be careful what you are giving up. Just because you CAN take money out of your retirement plan, doesn’t mean you should. Some annuity contracts are worth keeping. These are generally the ones with good minimum guarantees and where the insurance company is strong.
You will be facing surrender charges, in some cases large ones. These surrender charges must be weighed against the benefits. Generally, it makes sense to pay surrender charges when taking money out of variable annuity products (though you should understand any guarantees that might be available to you before doing so) and it usually makes sense as well with indexed annuities, but make sure you do the proper analysis.
You might not need to use this escape hatch. You already have the ability to “exchange” one 403(b) for another 403(b) within your school district’s plan. Research if there is another vendor available that is low-cost and high quality. We like Vanguard, Fidelity, CalSTRS Pension2, Aspire and a few others. Post your vendor list to the discussion board at 403bWise or on the Facebook group.
As far as I can tell, you can only take up to $100,000 for a Coronavirus related distribution once, even if repaid (if anyone has contra opinion and a cite, please provide). This means that if you take the distribution and repay it later using the above strategy and then have a need, you won't be eligible again (though you could potentially take a loan if you have assets still in the DC Plan).
Potential For Abuse
This is already being used by unscrupulous indexed annuity insurance agents. Teachers have already reached out to Dan Otter and myself with e-mails showing agents attempting to use the above provision to sell high-cost, toxic products, please send any e-mails or advertisements that you see to us and also warm your colleagues.
Scott Dauenhauer, CFP, MPAS, AIF
402(c)(8)(B) - Eligible Retirement Plan
(B) Eligible retirement plan The term “eligible retirement plan” means—
(i) an individual retirement account described in section 408(a),
(ii) an individual retirement annuity described in section 408(b) (other than an endowment contract),
(iii) a qualified trust,
(iv) an annuity plan described in section 403(a),
(v) an eligible deferred compensation plan described in section 457(b) which is maintained by an eligible employer described in section 457(e)(1)(A), and
(vi) an annuity contract described in section 403(b).
If any portion of an eligible rollover distribution is attributable to payments or distributions from a designated Roth account (as defined in section 402A), an eligible retirement plan with respect to such portion shall include only another designated Roth account and a Roth IRA.