By Steve Cleland, CPA
In recognition of the ongoing economic impact of the COVID-19 pandemic, the IRS has provided procedures to allow individuals to take early distributions from certain retirement plans under Section 2202 of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136. This provision is intended to ease the burden on taxpayers who may need access to additional funds during these unprecedented times. Released in June, Notice 2020-50 clarifies the procedures for withdrawing eligible funds and provides guidance on the various tax-reporting options related to these transactions.
Unfortunately, COVID-19 has forced many Americans to exhaust their savings and emergency funds. This has left many people questioning whether they will need to dip into retirement savings to cover current expenses. Under typical circumstances, a taxpayer who withdraws funds from a traditional retirement account before age 59½ is subject to a 10% additional tax for early withdrawal. Because of these penalties, as well as lost potential earnings, an early withdrawal from retirement savings is often treated as a last resort but is becoming all too necessary.
Congress recognized that, for many, the ability to access retirement savings is a necessary lifeline to financially weather the pandemic. Under the CARES Act, early withdrawals taken in 2020 due to COVID-19 hardships will not be subject to the 10% additional tax under Sec. 72(t) or the 25% additional tax on SIMPLE IRAs under Sec. 72(t)(6), if certain conditions are met.
In order to avoid the 10% penalty, the distribution must be made to a qualified individual from an eligible retirement plan between Jan. 1, 2020, and Dec. 30, 2020, and must be $100,000 or less in aggregate.
You are a qualified individual if –
The burden of proof falls on individuals to certify that they qualify, and employers or plan administrators are not required to verify the information unless they have actual knowledge contrary to the individual's certification.
The distribution must be made from an eligible retirement plan. Eligible plans include an IRA, 401(k), 401(a), an annuity such as a 403(a) or 403(b), and a governmental deferred compensation plan such as a 457(b). Distributions from these plans are ordinarily included in a taxpayer's gross income in the year of distribution and can ordinarily be directly rolled over.
The CARES Act allows individuals to report distributions ratably over three years. This means that an individual who withdraws $30,000 in 2020 may report $10,000 of income in 2020, 2021, and 2022.
A qualified individual may elect out of the three-year ratable income inclusion and instead include the entire amount in the year of the withdrawal. This election must be made by the date the tax return is filed and may not be changed afterward. Further, all COVID-19-related distributions must be treated consistently, either all reported fully in the tax year withdrawn or all reported ratably over three years. This will require planning on the part of the individual's CPA to determine the most tax-advantageous strategy for income timing.
It is also important to note that a qualified individual may decide to treat periodic payments and distributions that would have been required minimum distributions but for Section 2203 of the CARES Act and any distribution received as a beneficiary from an eligible retirement plan on or after Jan. 1, 2020, and before Dec. 31, 2020, as COVID-19-related, thus taking advantage of tax-preferential treatment for these withdrawals.
The CARES Act also provides that any part of a COVID-19-related distribution is eligible for tax-free rollover treatment to be recontributed to a qualified plan within three years of receipt and therefore excluded from income. Any amount recontributed is treated as a direct tax-free rollover where eligible or as an indirect rollover with the typical 60-day requirement adjusted to three years. A recontribution is not subject to the one-rollover-per-year limitation. Because the income reporting and recontribution can span three years, several timing options open the door to tax planning strategies and income-smoothing opportunities for taxpayers to take advantage of.
Similar to traditional IRA contributions, the deadline to recontribute is determined by the filing date of the tax return. If a distribution is taken in 2020 and recontributed prior to filing the 2020 tax return, which can be as late as Oct. 15, 2021, if extended, the income will be excludable on the 2020 tax return.
An individual is generally allowed to take a loan from a 401(k) plan for up to 50% of the vested account balance or up to $50,000, whichever is less, if the plan allows. The CARES Act adjusted these limits to 100% of the vested balance or up to $100,000, whichever is less. The loans ordinarily must be repaid within five years, and the CARES Act extends this by one year for loan payments due between March 27, 2020, and Dec. 31, 2020. This means that any payment that comes due between those dates may be delayed by up to one year and re-amortized over a period one year longer than the original loan term. This may help taxpayers who already have an outstanding loan from their 401(k) due to previous hardships, by providing a deferral of repayment and decreasing the required installment amounts by re-amortizing the loan over a longer period.
Takeaways and Planning Strategies
From a financial perspective, an individual is generally better off exhausting all other assets before dipping into retirement savings. While it is easy to take money from a retirement account, it is very difficult to replace the money at an equivalent value.
Given the above concerns, it still may make sense to take advantage of the provisions of Section 2202 of the CARES Act. No matter the potential consequences, it may be worthwhile taking an early withdrawal to secure basic needs, maintain housing, or avoid high-interest debt.
Please feel free to reach out to us if you have any questions on this topic.