SECURE Act Allows Parents to Withdraw $5,000 from IRA or 401(k) Penalty Free: A Welcome Reprieve for Families Struggling During the Pandemic
February 1, 2021
Overview of the Law: In December 2019, Congress passed the SECURE Act (“Act”), allowing parents to withdraw up to $5,000 out of their IRAs or 401(k) plans following the birth or adoption of a child, without paying the 10% early withdrawal penalty. Although no 10% early withdrawal penalty applies, this option may not be recommended for all eligible parents.
Background Regarding Early Withdrawal Penalties: Prior to the Act, if you were under the age of 59½ and withdrew pre-tax money from an IRA or 401(k) plan, the withdrawal was subject to a 10% early withdrawal penalty (in addition to the assessment of ordinary income tax). Prior to December 2019, there was a list of exceptions to the 10% early withdrawal penalty. For example, a distribution may have been exempt if you became permanently disabled or if you used the funds to pay certain medical expenses. Welcoming a new child to the family, however, was not on that list.
How it Works Under the New Law: After the birth or adoption of a child, a parent is allowed to distribute up to $5,000 out of either an IRA or a 401(k) plan. Importantly, the withdrawal must be taken after the child is born or adopted. Parents have up to one year following the date of birth to process the distribution from their retirement accounts to avoid the 10% early withdrawal penalty. The $5,000 limit is available to each parent, meaning each parent can elect to take a distribution from their respective retirement account for a combined distribution of $10,000. The 10% early withdrawal exemption is available for each child that is born, and there is no lifetime limit. Even better, the law does not require you to keep track of expenditures. The birth or adoption of your child is the “qualifying event” which makes you eligible for the penalty-free distribution.
Beware of the Income Tax Implications: Although parents avoid having to pay the 10% early withdrawal penalty, the $5,000 withdrawal still represents taxable income in the year the distribution occurs. If the parents live in Colorado and make a combined income of $100,000 in 2020, that $5,000 is subject to federal income tax of 22% and state income tax of 4.63%. If you and your partner plan to distribute the full $5,000 out of your retirement accounts and you are in a medium to high tax bracket, you should consult with your financial advisor or attorney about the timing of the distributions. With proper planning, there may be a way to lower the income tax implications and out of pocket expense associated with the distributions.
Tax Credit: Under the current tax laws, there is a $2,000 federal tax credit for dependent children, which would drastically reduce the tax liability created by the $5,000 distribution. Nonetheless, the $2,000 tax credit could be used to reduce the parents’ existing tax liability dollar-for-dollar if the distribution is not taken.
Ability to Repay the Distribution: The new law also offers parents the option to repay the amounts to their retirement account that were distributed due to a qualified birth or adoption. The repayment of the amounts previously distributed from the IRA or 401(k) would be in addition to the annual contribution limits. There is not a lot of clarity at this point as to how these “repayments” will work, but we do know that certain limitations or restrictions may apply.
Not Recommended for Everyone: While the new withdrawal exemption may help cover the short-term expenses associated with welcoming a new child into the family, you should always consider other options before tapping into your retirement funds. While the increased access to funds is great, it is important to understand how taking a withdrawal will affect your overall financial situation, including any potential liabilities. Consult your trusted financial advisor or attorney to discuss whether this option is right for you.
Not Available to Everyone: Starting back on January 1, 2020, the 10% early withdrawal exception applied to all pre-tax IRA accounts but it did not automatically apply to all 401(k), 403(b), or other types of qualified employer sponsored retirement plans. While the Act authorizes these penalty free distributions, companies can decide whether they want to provide this special distribution option to their employees. You will need to contact your employer or third-party administrator to find out whether the plan includes this option.
Nomination of Guardian: It is always a good idea for new parents to revisit their existing estate plan after welcoming a child to the family. If you do not have an estate plan, you should strongly consider making one. A properly executed estate plan will include a nomination of guardian for your child. A nomination of guardian is a written declaration that names a person or persons to serve as guardian of your child if you die or become incapacitated.