Key Issue: CARES Act 403(b) Escape Hatch?
April 10, 2020
How would you like to trade your terrible 403(b) vendor for Vanguard? 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.
Coronavirus Related Distributions
The recently enacted CARES Act allows 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. You have up to three years to return the money. The key is that the 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.
From Outhouse to Vanguard
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 rollover IRA with the vendor of their choice. This could potentially saving 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.
Is It Really That Simple?
Yes and no. The strategy is completely legal and rather straight forward. The quesiton is whether one qualifies for the distribution. As of this writing in early April 2020 there is some ambiguity.
Up to $100,000 aggregated across all accounts will not be subject to the 10% early withdrawal penalty. To qualify you must have been affected by COVID-19, but what qualifies is quite broad. The following scenarios qualify you, according to Jeffrey Levine of kitces.com.
- Have been diagnosed with COVID-19
- Have a spouse or dependent who has been diagnosed with COVID-19
- Experience adverse financial consequences as a result of being quarantined, furloughed, being laid off, or having work hours reduced because of the disease
- Are unable to work because they lack childcare as a result of the disease
- Own a business that has closed or operate under reduced hours because of the disease; or
- Meet some other reason that the IRS decides is permissible
My biggest concern is how the term quarantine will be defined by the IRS. There has been no word from the Treasury Department as to how they view the term. Given that 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 which wrote:
“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 soon.
You will need a distribution form from your current vendor and a transaction request form from your compliance administrator. This is a “coronavirus-related distribution.” This is NOT a hardship withdrawal. It’s very important that this transaction 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 to your current 403(b) or 457(b) vendor. The vendor should process and send you a check for up to $100,000. You are to first deposit this entire amount into 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 a traditional 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). That's how you rescue up to $100,000 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 until 2021 or later, you will owe taxes on the withdrawal.
This money 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). This usually makes sense with indexed annuities as we, but be sure to 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 employer’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 403bwise discussion board and/or the 403bwise Facebook group to see what others think (update as of April 16, 2020, several in our Facebook Group are investigating exploring this provision. We will keep you apprised of their progress.
Potential For Abuse
This "escape hatch" is already being used by unscrupulous indexed-annuity insurance agents to put teachers into terrible products. Teachers have already reached out to Dan Otter of 403bwise.org and myself with e-mails showing agents attempting to use this provision to sell high-cost, toxic products. Please share any e-mails or advertisements you come across. And please warn and inform your colleagues.
Scott Dauenhauer, CFP®, MPAS, AIF
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