“I would like to take an early distribution from my nonprofit 403 b retirement plan so I can quit my job and travel. What are the 403 b distribution rules? What will be the tax consequences if I am unemployed or working free-lance at that point?”
This was one of the questions I was asked during a financial planning and investment educational session a couple of years ago. Ah, to be in those times once again when we pondered such things! I am no longer being asked this type of question amidst the job losses and early retirement scenarios of COVID19, and yet I have gotten questions about 403 b retirement plan distribution rules and whether participants can take early distributions based on the recent CARES Act. Participants also want to know when to rollover from an employer retirement plan.
For Employees, Laid-Off Workers or New Retirees:
The way the question was asked during that session two years ago concerned me, however, as it highlighted the fact that many younger career people may not fully value their retirement savings accounts and may not understand the 403 b distribution rules. In fact, this young woman said “I’ll have plenty of time to save later. I’m young and want to experience life now.” I get that. I am forever grateful for the trips and adventures I had in my twenties and early thirties.
“You will learn how to budget yourself if you start saving as much as you can now (for retirement) and increase every time you receive a raise.”
~Words from a wise father
However, I was lucky to work in the financial advisory industry right out of college where I learned the power of investing, compounding as well as the 401 k and 403 b distribution rules. I knew for example that I would incur a 10% penalty PLUS taxes if I took a distribution before I was 59 and a half. I was also lucky to have my Dad sit me down and insist, even on my meager, entry-level salary, that I contribute the maximum to my retirement plan. My father said, “You will learn how to budget yourself if you start saving as much as you can now and increase every time you receive a raise.”
Times are different now where 1 in 4 are unemployed, some nonprofits are facing closure and others are staying afloat with revised, lower funding targets as we all look to re-tool and pivot our service or business models. If you were lucky enough to have a 401(k) or 403(b) at your previous employer, you have some decisions to make. If you were personally impacted by the Coronavirus either by testing positive, needing medical treatment or laid off, you may access your retirement plan money now through a provision of the CARES Act.
If you need money immediately beyond unemployment benefits or your emergency savings accounts, you may borrow from your 401(k), 403(b) or IRA accounts for up to $100,000 per person. Per the CARES act 403 b distribution rules, you have 3 years to pay the loan back to yourself. Think carefully before you proceed down this path as you will need to pay income tax on this money and then file an amended tax return once you re-deposit the funds back into your account.
In addition, if you are unemployed at the moment and you are using healthcare coverage through the affordable care act, you will want to think through how this additional distribution of income may impact any cost-sharing reductions you’ll receive. The federal government provides a calculator so you can estimate your 2020 income and potential cost-sharing reductions.
“Nearly half of U.S. Families have no retirement savings at all.”
~Economic Policy Institute
You will also want to consider the impact on your future retirement savings if you take a distribution. Have you saved enough currently or will take the distribution PLUS not contributing for 6 to 12 months set you back further?
In talking to a retirement plan administrator recently, he said that 90% of participants who took distributions from their plans in the Great Recession of 2008, did not replace those funds back into their plans. What does this mean long term?
Our retirement plans serve a dual purpose: they reduce our taxable income AND set us up for income in retirement since social security is only meant to be a “stop gap” measure for most people. We have a critical retirement savings gap in the US. According to the Economic Policy Institute, nearly half of families have no retirement savings at all. If you start saving early in your career, even if only a little to start, your investment savings will compound over the course of your working career. The same goes for replacing those funds you borrow from your retirement account.
If you do not need the money immediately, you may want to consider whether to rollover your money from your employer’s 401(k) or 403(b) plan to an IRA. There are benefits and drawbacks to these options:
Benefits to an IRA Rollover:
- Broader investment selection. Typically, if you rollover to an IRA, you can select from thousands of mutual funds, stocks and ETFs.
- Possible lower costs. You should review the Plan Document for your 403(b) plan which will list the underlying costs for both the funds in the plan and should list the administration costs for your plan. As if often the case in the industry, the plan participants pay for administration through the funds in the plan. If you open an IRA account at Schwab, TD or Fidelity, they typically will not charge for the account.
- No penalties or taxes. If you perform a direct rollover from your 403(b) or 401(k) to an IRA you won’t pay penalties or taxes.
Drawbacks to an IRA Rollover:
- Loans: Outside of the CARES Act, you cannot typically take a loan from an IRA.
- RMDs: Both IRAs and 403(b)/401(k) plans require minimum distributions beginning at age 72. However, a 403(b)/401(k) allows you to push off these RMDs until you actually retire, even if it is after age 72.
- Separation of service after 55: The IRS does provide an exception to distributions if you separate from service with your employer if the separation occurred in or after the year you turned 55.
- Limited creditor protection: Most pension plans such as pension, profit sharing, 403(b), 401(k) and 457 plans are protected in bankruptcy and against claims from creditors. IRA protections vary from state to state so it is important to check the rules in your state.
- ESOPs: Some qualified defined contribution plans have employee stock ownership plans (ESOPs). This stock should be handled slightly differently, and you will need to check with a qualified accountant. It is likely this should be rolled into a regular brokerage account.
I am hearing from more HR managers, Finance Directors and Chief Financial Officers of nonprofits and even for-profit organizations that their employees are either taking distributions or are stopping their contributions to their retirement plans. This may be for a variety of reasons: a laid of spouse or partner, an unexpected illness or major expenses, support for other family members, etc.
I sometimes find that it is a lack of financial education and awareness that can trigger this activity. Some employees do not realize that by stopping their retirement contributions, they are now potentially increasing their gross salary. Other times, employees believe they must pay down their student or car loan debt BEFORE they can begin contributions to a retirement plan. With loan rates at historic lows, this does not have to be the case.
Still more employees are unaware of the employer match amount, so do not contribute to the plan. Other employees do not understand 403 b distribution rules and penalties before they make withdraws. In smaller organizations, I find that new employees might not understand the matching contribution process, especially if they have never participated in a plan.
As an executive overseeing your organization’s retirement plan, here are steps you can take to consider increasing participation in your plan or educating employees about the impact of distributions:
- Quarterly Reviews: Review your organization’s current plan participant population on a quarterly basis with your retirement plan administrator. What is the quarter over quarter increase or decrease in participants, contributions, distributions?
- Education Sessions: Ask your Retirement Plan Advisor or Retirement Plan Administrator to provide an educational session for your employees beyond the annual group meeting. Some advisors and administrators have online tools and videos which can be disseminated on a regular basis to employees.
- Plan Design Changes: Consider an automatic enrollment plan for your organization. As the IRA indicates, this plan allows you to “enroll” eligible employees in the retirement plan automatically unless your employee affirmatively elects not to participate. “Enroll” means that the employer contributes part of the employee’s wages to the retirement plan on the employee’s behalf. The employee can then opt not to contribute to the plan OR they can contribute a different amount.
- Quarterly Communications: Partner with your retirement plan administrator or advisor to develop a quarterly communications update to employees via email or social media to encourage education about the retirement plan.
If you are not receiving ideas or support from your plan advisor or plan administrator, then perhaps its tine to evaluate your providers. In this time of the pandemic, it is more important than ever to educate employees and plan participants on your organization’s benefits, including the retirement plan.
Talk to the financial experts at Fairlight Advisors to learn more about managing your nonprofit’s investments. Schedule a free consultation today!