By Joyce Beebe, Ph.D.
Fellow in Public Finance
Congress passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act in late December 2019, revising the rules to tax-preferred retirement plans by, for example, increasing the required minimum distribution age, expanding multiple employer programs and limiting stretch IRA distributions. Although not entirely related to retirement, the SECURE Act includes a lesser-known provision that affects new parents’ financial stability. In the same week, Congress passed another law granting paid parental leave to federal workers. This article reviews the similarities and differences between these two policies relevant to families.
SECURE Act: New Parent Exception to Tax Penalty on Early Distribution
Prior to the SECURE Act, early withdrawals before age 59½ from tax-preferred retirement saving accounts such as IRAs and 401(k)s were usually subject to a 10% penalty, and the withdrawals were included in an individual’s taxable income. However, there were a number of exceptions where the early withdrawals would not be subject to the 10% penalty. In certain cases, the early withdrawals would be subject to penalty under one type of retirement saving program but not the other. For instance, if a taxpayer took money out of her IRA to pay for qualified higher education expenses when she was younger than 59½, she would not be subject to penalty. She would also not need to pay the penalty if she took an early distribution (up to $10,000) from her IRA to purchase her first home. However, if she instead took money out of a 401(k) for similar purposes, the penalty would apply.
The SECURE Act adds another qualified exception for both IRAs and 401(k)s to this laundry list. It allows each parent to take out up to $5,000 if they have a newborn, a newly adopted or a newly fostered child. If both parents take early distribution, they can take out $10,000 together. New parents have up to one year after the child’s birth or arrival to take the early withdrawal; as a result, the cash is not intended to be used for costs incurred before birth. The congressional Joint Committee on Taxation estimates that this provision would cost about $1.2 billion over the next 10 years.
It is worth emphasizing that the early withdrawal penalty waiver in the SECURE Act does not really grant new parents leave time. Instead, it allows parents to use the money to buy time off from work, combined with the current non-paid federal Family and Medical Leave Act policy. A new child certainly adds extra expenses to the family’s budget; however, whether parents will use the early distribution to finance personal time off, just like they would for purchasing clothes or baby food, is uncertain.
Furthermore, if we keep adding to the list of exceptions, the tax-favored retirement accounts would not only get administratively complex, they would essentially function as de facto government-sponsored emergency cash instead of retirement savings. This begs the question of whether or not the federal government should be the administrator of such an emergency fund and be the one to handle all the administrative paperwork.
From a retirement financial security perspective, the early withdrawal penalty exemption essentially advances the new parents’ future savings for their current consumption, and because the withdrawal shortens the number of years the money can grow in a tax-deferred account, it could compromise account holders’ retirement financial safety if not adequately replenished.
In addition, because the proceeds are taxed as ordinary income, it is not “free money” to the parents. In fact, it would be wise to think of the funds as being taxed at the taxpayers’ highest marginal personal income tax rates. For instance, if a married couple filing a joint return and earning a combined $65,000 (close to the U.S. median household income) per year choose to withdraw the full $10,000 based on the new provision, they could see their additional income taxed at approximately a 20% rate depending on their circumstances and other deductions. As such, although the SECURE Act provides an option for penalty-free withdrawal, it would be wise for new parents to take this as a last resort.
Paid Parental Leave for Federal Workers
Around the same time that the SECURE Act became law, Congress also granted 2.1 million federal workers up to 12 weeks paid parental leave following childbirth or adoption. Somewhat similar to how the SECURE Act was embedded in the spending bill that prevented a federal government shutdown, the policy benefitting federal workers who are new parents was tucked into the National Defense Authorization Act, which authorizes procurement of military aircraft, weapons, combat vehicles and missiles.
The paid parental leave provision for federal workers has generated favorable and unfavorable reactions. Some question whether it is fair that federal workers, funded with taxpayer money, receive paid parental leave when the majority of U.S. private sector workers have no access to such benefit. Indeed, the Congressional Budget Office estimates the cost of the federal parental leave benefit at $3.3 billion from FY 2020 to FY 2024 and $8.1 billion from FY 2020 to FY 2029.
Supporters of the paid parental leave policy state that gaining paid parental leave is not a zero-sum game between private sector working parents and federal workers. Instead, people should applaud that more U.S. workers have gained paid parental leave benefits to care for their children and that we are one step closer to comprehensive coverage. Over the last few years, more and more large companies have added paid parental or family leave as benefits to attract talent and to retain workers. This year, the federal government, one of the largest employers in the country, also joins the group.
The challenge of expanding parental leave benefits still exists for small companies and low-income workers who are less likely to have coverage. From this perspective, it is a pity that the two-year tax credit for establishing a paid leave policy was not extended beyond 2019. The of 2017 established a pilot provision that offered federal tax credits of up to 25% to employers who provide 12 weeks of paid family leave. The program is unique because it targets low-to middle-income workers, as employers are only eligible for the tax credit if they provide benefits to employees with wages lower than $72,000. The Paid Family Leave Pilot Extension Act was introduced in Congress but has not advanced.
Beginning in 2020, new parents will have more financial benefits and protections thanks to these two policies. To a certain extent, whether a worker gets paid parental leave still depends on where he lives and works in the U.S. Granting federal workers paid parental leave is an important milestone for supporters of paid leave policies. The next steps are to expand the benefit to small business workers and workers with moderate income and to enhance the leave coverage to workers themselves and their sick family members.