Author Topic: CARES act 401k withdrawal  (Read 1197 times)

jdec20

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CARES act 401k withdrawal
« on: April 10, 2020, 08:59:38 PM »
Theoretical question. Anyone thinking about taking a distribution (assuming you are qualified), investing said distribution, and then paying back the principal within the 3 year timeframe, thereby ostensibly transferring the gains into a taxable account vice stuck in a tax deferred account? Just curious what your thoughts are. Thanks!

MDM

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Re: CARES act 401k withdrawal
« Reply #1 on: April 10, 2020, 09:49:39 PM »
Depending on one's current and future tax brackets, having money "stuck" in a tax deferred account may be a favorable thing.

What assumptions are you using for the tax treatment of your investments?

MustacheAndaHalf

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Re: CARES act 401k withdrawal
« Reply #2 on: April 11, 2020, 01:57:54 AM »
It sounds like you have money invested in stocks, and it's inside a 401(k).  If you remove it and invest it in stocks, why would it grow faster?  First you'll lose each time the stocks pay dividends, since you will owe tax on them the next year - instead of delaying it.  And when you finish growing stocks outside your 401(k), you sell and pay the taxable gain.

It sounds like a way to volunteer for taxation now, instead of leaving them in an account where you pay taxes later.

Dicey

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Re: CARES act 401k withdrawal
« Reply #3 on: April 11, 2020, 04:50:03 AM »
I've had similar thoughts. I've decided it's not worth the effort. Today, I finally looked at our investments. We have a broad portfolio and we're only down 10% as of Friday's close. Iinertia wins again.

jdec20

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Re: CARES act 401k withdrawal
« Reply #4 on: April 11, 2020, 07:29:38 AM »
Thank you for the replies. I appreciate the thoughtful input.
@MDM, I think it would make sense for someone trying to hedge the tax bracket assumptions (i.e. guessing whether you will be in a higher tax bracket now vice when you retire).

@MustacheAndaHalf, The stocks don’t need to grow “faster,” in fact, they simply need to grow at the same rate that they would have grown in the tax deferred account. Ex. 100k left in 401k grows to 130k in three years, you will then pay taxes on 130k (and whatever compounding occurs) when you finally take the money out in retirement. In my example, you would take the 100k from the 401k, invest it in the SAME asset (lets say VFIAX) and it grows to 130k in three years. You will then return the 100k to your 401k and leave the 30k in your taxable account. Ostensibly, this allows you to access 30k without paying a penalty.

@Dicey, nice! Hopefully we don’t experience another drop in the market soon!

MustacheAndaHalf

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Re: CARES act 401k withdrawal
« Reply #5 on: April 11, 2020, 09:50:48 AM »
Dividing VTSAX's last 4 quarterly dividends by the stock price, I get a 1.9% divided.  Call that 2%.

(0) this example 401(k) starts with 100k, and all withdrawn at the start
(1) First year it grows to 110k, and issues a 2% dividend of $2,200 (taxable)
(2) Second year it grows to 121k and another 2% dividend of $2,420, triggering more taxes.
(3) Third and final year growth to 133k and the last 2% dividend of $2,660 with more taxes owed.
On average, the stock grew by +33%.  You can sell later lots, but it's roughly a +33% gain.
Selling $100k with a cost basis of about $75k means owing the tax on a $25k gain.
The $100k is then returned to a 401(k) plan with no growth over 3 years.

Taxes are owed on $25k + $7.3k = $32.3k.
In this example, $33k is extracted from a 401(k) and taxes are owed on $32.3k of gains.

MDM

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Re: CARES act 401k withdrawal
« Reply #6 on: April 11, 2020, 09:57:52 AM »
In my example, you would take the 100k from the 401k, invest it in the SAME asset (lets say VFIAX) and it grows to 130k in three years.
Except it may not grow to $130K in a taxable account.  If one is paying 15% tax on dividends and capital gains (could be less if income is low; could be more if state taxes are present) then if 2%/yr comes from dividends the after tax amount is $125,426.

Similar point to what MustacheAndaHalf just posted.

TaronM

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Re: CARES act 401k withdrawal
« Reply #7 on: April 11, 2020, 12:41:34 PM »
Dividing VTSAX's last 4 quarterly dividends by the stock price, I get a 1.9% divided.  Call that 2%.

(0) this example 401(k) starts with 100k, and all withdrawn at the start
(1) First year it grows to 110k, and issues a 2% dividend of $2,200 (taxable)
(2) Second year it grows to 121k and another 2% dividend of $2,420, triggering more taxes.
(3) Third and final year growth to 133k and the last 2% dividend of $2,660 with more taxes owed.
On average, the stock grew by +33%.  You can sell later lots, but it's roughly a +33% gain.
Selling $100k with a cost basis of about $75k means owing the tax on a $25k gain.
The $100k is then returned to a 401(k) plan with no growth over 3 years.

Taxes are owed on $25k + $7.3k = $32.3k.
In this example, $33k is extracted from a 401(k) and taxes are owed on $32.3k of gains.

That really depends a lot on your situation. In my situation, where I'm 42, retired in a state with no income taxes, spend $30k a year, MFJ status, but unfortunately most of my stash is in pre-tax retirement accounts, here is the tax ramifications (pretending inflation doesn't exist):

Do nothing:

(1) Eventually what is in my Brokerage runs out long before I'm 59.5.
(2) Start pulling the $30k out of pre-tax accounts.
(3) Tax: 10% of $30k early withdrawal penalty + 10% tax on amount above standard deduction = $3,520.
To cover the tax, I actually have to pull more out of investments, which are then taxed, etc, making it difficult to quickly calculate the exact amount of tax I'd end up paying, but suffice to say actual tax would end up being more than $3,520 / year.

Do what you said:

(0) this example 401(k) starts with 100k, and all withdrawn at the start
(1) First year it grows to 110k, and issues a 2% dividend of $2,200. I don't pay any tax on that, since it would fall under Standard Deduction with my not yet needing to pull from traditional accounts. $0 in tax
(2) Second year it grows to 121k and another 2% dividend of $2,420, triggering more taxes in theory, except those would all be qualified dividends, and those dividends would clearly be less than the $80,000 qualified dividend tax bracket of 0%, since I only have $30k expenses (and therefore income) per year. $0 in tax
(3) Third and final year growth to 133k and the last 2% dividend of $2,660 with once again $0 in tax
(4) Sell to put the money back with $25k gain. Again, $25k + the gains on the $30k/year I normally sell for expenses is still far below the $80k + SD which is taxed at 0%. And that's assuming I didn't take advantage of capital gains harvesting in the prior 2 years. $0 in tax

Result: $33k is in brokerage that would have been in the 401k, no taxes paid for the transfer. That $33k still continues to get gains on it's own as well, and will be taxed at a much more favorable rate (0%) compared to having that $33k of gains be in the 401k (10% early withdrawal penalty + taxed as normal income not LTCG).

I'd be surprised if any one claiming to follow the MMM frugality path would generate more than $80k + $24.8k of LTCG income in a single year just to cover their expenses. I mean, if you did this after doubling your investments, you'd be able to sell and spend $200k worth of stocks from a brokerage in a single year and still pay $0 in taxes, since only half of that would be gains and would fall under the 0% LTCG bracket! So, no one here that is already FIRE'd should ever need to pay taxes on stocks sold in a brokerage. But money pulled from a pre-tax retirement account is going to cost you 10% before 59.5, plus 10% or more on any amount > $24.8k you pull in a single year, which is way more restrictive. Even after 59.5, withdrawals from pre-tax accounts are still taxed as regular income, rather than the preferential treatment of long-term capital gains from stocks sold in a brokerage.

Therefore, stocks in a "taxable" brokerage is essentially tax-free post-early-retirement, and only stocks in a pre-tax retirement account (or gains in a Roth) is likely to cost you taxes when you sell them and spend the money. And, thus, the more stocks you can get to be in your brokerage instead of your 401k (without paying taxes on the transfer), the better.

A Roth Ladder can of course do the same thing (for as long as it remains legal), but it is much more limited since it is hard to not end up paying income tax on the Roth conversions themselves (they are taxed as regular income not as LTCG), and if you keep them small enough to not be taxed you may not be converting enough each year to keep up with future expenses, so you'll have to pay taxes on the 401k money one way or the other (either from the conversions themselves or from not converting enough and paying taxes on early withdrawals later). SEPP is also much more limited than some people make it out to be (I've looked into it, it would not let me pull out enough to live off of, plus it is a pretty permanent and restrictive change with respect to changing my mind and getting a job later).

So, yeah, I'm doing exactly with the first post said. But, my concern, reading the actual bill itself, is does it truly mean I won't have to pay any tax on the $100k until I put it back in 3 years? How does the IRS know at the end of year 1 that I intend to put it back later? Will I have to pay taxes then, and then get a refund later when I put it back? Or will I even get a refund after year 3 for the taxes I paid in year 1 and 2 on it? Or do I have to put a 3rd of it back each year to avoid taxes entirely? Or what if I say I will put it back and then change my mind later, do I pay back-taxes for the previous 2 years or does the "pay only 1/3rd of it per year" thing start at year 3 when I changed my mind about putting it back? I haven't been able to get straight answers about this yet, and worry I may not know until the actual tax forms are released around Feb or so of 2021...

Either way, given the market being low when I took it out, I'll get at least 1 year's worth of decent gains to be in the brokerage (assuming the market has decently recovered in a year) which, as explained above, is a great thing for my taxes and my ability to stay FIRE'd (I only just barely have enough as it is, so every little trick helps, since I didn't originally intend to FIRE but rather realized after health issues made it more difficult to get a job in my field that I had enough saved up that I could just live frugally and retire immediately). If it turns out that I'd have to pay taxes before year 3 after all, I can just put it back after 1 year and call it a small win.
« Last Edit: April 11, 2020, 12:49:14 PM by TaronM »

MDM

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Re: CARES act 401k withdrawal
« Reply #8 on: April 11, 2020, 01:00:15 PM »
But, my concern, reading the actual bill itself, is does it truly mean I won't have to pay any tax on the $100k until I put it back in 3 years?
No.  You would have to claim either $100K income for 2020, or $33,333 in 2020 with the intention of claiming the same in 2021 and 2022.

Best guess is that if you do repay it later, you will need to file amended returns for the years in which you claimed the income.

Quote
To cover the tax, I actually have to pull more out of investments, which are then taxed, etc, making it difficult to quickly calculate the exact amount of tax I'd end up paying,
If you are paying the same tax rate on the entire withdrawal, you withdraw (spending need)/(1 - tax_rate).  E.g., if taxed at 12% on all $35 you would withdraw $35K/(1 - 0.12) = $39,773.  Does get a little trickier if you have different marginal rates for different withdrawal amounts.

TaronM

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Re: CARES act 401k withdrawal
« Reply #9 on: April 11, 2020, 01:11:20 PM »
But, my concern, reading the actual bill itself, is does it truly mean I won't have to pay any tax on the $100k until I put it back in 3 years?
No.  You would have to claim either $100K income for 2020, or $33,333 in 2020 with the intention of claiming the same in 2021 and 2022.

Best guess is that if you do repay it later, you will need to file amended returns for the years in which you claimed the income.

So in year 1 I would pay taxes on $33k of extra income, year 2 I would do the same, then year 3 after putting it back, I would pay no taxes, plus get a refund on the taxes I previously paid via amended returns?

Yet various articles from investment-focused publications have mentioned pulling the $100k out for 3 years and then putting it back and paying no taxes at all. I guess that's technically true in the long run, but seems they should have mentioned paying taxes temporarily (and missing out on any gains those tax funds would have earned in the meantime). Some even specifically suggested the opposite of what you say here though - that you'd pay no taxes for the entire 3 years, but if you didn't put it back by the time limit, you'd have to file amended returns and pay back taxes for the prior years...

Has the IRS or congress released specific guidance to support what you say? It does make sense but I haven't seen consistency from claims on how it will work.

If you are paying the same tax rate on the entire withdrawal, you withdraw (spending need)/(1 - tax_rate).  E.g., if taxed at 12% on all $35 you would withdraw $35K/(1 - 0.12) = $39,773.  Does get a little trickier if you have different marginal rates for different withdrawal amounts.

Thanks, I was too lazy to look up the formula, but good to know it isn't hard to calculate later. I'll likely need that at some point to calculate how much to pull out to be able to cover my expenses + pay the taxes on the amount I'm pulling out, once my brokerage runs out.
« Last Edit: April 11, 2020, 01:13:40 PM by TaronM »

MDM

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Re: CARES act 401k withdrawal
« Reply #10 on: April 11, 2020, 01:18:54 PM »
Some even specifically suggested the opposite of what you say here though - that you'd pay no taxes for the entire 3 years, but if you didn't put it back by the time limit, you'd have to file amended returns and pay back taxes for the prior years...

Has the IRS or congress released specific guidance to support what you say? It does make sense but I haven't seen consistency from claims on how it will work.
See "(5) INCOME INCLUSION SPREAD OVER 3-YEAR PERIOD" in SEC. 2202. Special rules for use of retirement funds.  Seems one has to include it as income, in which case there would be whatever tax liability for the year of income.

TaronM

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Re: CARES act 401k withdrawal
« Reply #11 on: April 11, 2020, 02:58:12 PM »
Some even specifically suggested the opposite of what you say here though - that you'd pay no taxes for the entire 3 years, but if you didn't put it back by the time limit, you'd have to file amended returns and pay back taxes for the prior years...

Has the IRS or congress released specific guidance to support what you say? It does make sense but I haven't seen consistency from claims on how it will work.
See "(5) INCOME INCLUSION SPREAD OVER 3-YEAR PERIOD" in SEC. 2202. Special rules for use of retirement funds.  Seems one has to include it as income, in which case there would be whatever tax liability for the year of income.

I agree that is the most likely outcome, but it also says in Section 2022(a)(3)(B & C) that re-contributing the money within a 3 year period qualifies it as a "trustee-to-trustee rollover", which normally has a 60-day time limit but that time limit has been extended to 3 years in this case, which thus would not be taxable. So according to that, taking money out and then putting it back in 3 years should be a non-taxable event.

It's just a question of what happens in the interim, when the IRS does not yet know if you intend to keep the money (thus get taxed, with the allowance to split it over 3 years if you choose to) or return the money (thus not get taxed, because it is treated as just a rollover which has no tax consequences).

It would seem they could either expect you to pay tax, then after the "rollover" amend your prior returns and get refunded on the taxes (or maybe you just count the entire 100k as a reduction of income only for the year you actually returned it, which would suck). Or they could expect you not to pay the tax (just in case you do intend to treat it as a rollover later), and then if you end up keeping it anyway, you amend your prior returns and pay back taxes. Or maybe in that case, instead of back taxes you pay taxes from that point forward (so you pay 33k of income tax for years 3, 4, and 5 since you didn't officially "keep" the rollover money until after the 3 year rollover time limit expired).

Some have also suggested maybe if you re-contribute a 3rd of it every year you wouldn't get taxed. Personally, I suspect that would just mean you'd be taxed 1/3rd of the remaining amount, so if you put back in 33k in year 1 then you have 66k leftover which would be taxed at 22k for that year if you divide it in 3.
« Last Edit: April 11, 2020, 03:10:49 PM by TaronM »

MDM

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Re: CARES act 401k withdrawal
« Reply #12 on: April 11, 2020, 03:41:33 PM »
It would seem they could either expect you to pay tax, then after the "rollover" amend your prior returns and get refunded on the taxes
That's my guess, but it is just a guess.

Quote
Some have also suggested maybe if you re-contribute a 3rd of it every year you wouldn't get taxed.
That is consistent with claiming 1/3 the income each year: income and re-contribution net to $0.