Editor: Mark G. Cook, CPA, CGMA
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, whether due to decreasing income, increasing expenses, or both, for a prolonged period of time. 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, barring other extenuating circumstances. 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. 31, 2020, and must be $100,000 or less in aggregate.
Requirements for eligible early withdrawals
The first requirement is that the distribution is made to a qualified individual. The definition of a qualified individual in Section 2202(a)(4)(A)(ii) of the CARES Act is fairly generous. A qualified individual is anyone who has been diagnosed with COVID-19 by a test approved by the Centers for Disease Control and Prevention or has experienced adverse financial consequences due to being quarantined, furloughed, or laid off; having work hours or pay reduced; having been unable to work due to a lack of child care; having owned or operated a business that has been closed; having a reduction in self-employment income; or having a job offer rescinded or a start date delayed. An individual also qualifies if his or her spouse or a member of his or her direct household has experienced any of the above.
Additionally, a qualified individual is not required to demonstrate a true need for the funds in order to take advantage of this provision. As long as an individual has experienced adverse financial consequences for any of the reasons above, an early distribution is allowed. Similarly, distributions are not limited in amount to the extent of adverse financial consequences experienced.
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. There is an example of a simple taxpayer certification in Section 2.E of Notice 2020-50.
The second requirement is that the distribution is 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 third requirement is that the distribution is made in calendar year 2020, which is straightforward.
The final requirement is that the aggregate distributions eligible for COVID-19 relief are not to exceed $100,000 per individual. This means a single employer or plan administrator cannot distribute in excess of $100,000 to an individual as COVID-19 relief. An individual may receive distributions from multiple unrelated plans that exceed $100,000 in aggregate, but the individual may only exclude up to $100,000 from the 10% additional tax penalty.
Provided all these conditions are met, the eligible distributions must be reported as income and are subject to income tax, but without additional tax or penalty for early distribution. 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.
Tip: If a taxpayer decides to report a distribution ratably over three years but dies before the third year, the remaining deferred income must be reported in the year of death.
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 a savvy CPA 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. This leads to several timing scenarios, which are most easily explained through examples:
Example 1. Year 1 distribution is recontributed in year 1: A $30,000 qualified distribution is taken in 2020. The entire $30,000 is recontributed in April 2021, before filing the 2020 tax return. The $30,000 will be excluded from 2020 income on the 2020 tax return.
Example 2. Year 1 distribution is reported in year 1 and recontributed in year 3: A $30,000 qualified distribution is taken in 2020. The entire amount is reported as income on the 2020 tax return. The $30,000 is then recontributed in 2022. The taxpayer will be allowed to amend the 2020 return to remove the $30,000 from income.
Example 3. Year 1 distribution is reported ratably over three years and fully recontributed in year 2: A $30,000 qualified distribution is taken in 2020. The distribution is reported ratably, with $10,000 of income to be reported in 2020, 2021, and 2022. In 2021, after filing the 2020 tax return, the taxpayer recontributes $30,000. The taxpayer may amend the 2020 tax return to remove the $10,000 of income previously reported and may exclude the remaining $10,000 of income in both 2021 and 2022.
Example 4. Year 1 distribution is reported ratably over three years and partially recontributed in year 2: A $30,000 qualified distribution is taken in 2020. The distribution is reported ratably, with $10,000 of income to be reported in 2020, 2021, and 2022. In 2021, after filing the 2020 tax return, the taxpayer recontributes $15,000. The taxpayer now has options. The recontribution must first offset the current year's income, so $10,000 must be excluded from the 2021 tax return. The taxpayer then has the option to carry the remaining $5,000 forward to offset 2022 income or carry it back to 2020 by amending the 2020 tax return.
The IRS has not yet provided specific information about how the above transactions will be reported, but taxpayers will use Form 8915-E, Qualified 2020 Disaster Retirement Plan Distributions and Repayments, which is anticipated to be released by the end of 2020.
Tip: A distribution is not eligible for recontribution if it is structured through the employer or plan administrator as a hardship withdrawal rather than as a COVID-19-related distribution.
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 reamortized 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 reamortizing the loan over a longer period.
Requirements for plan administrators
The plan administrator is required to report the payment of any distribution to a qualified individual on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. This reporting is required even if the individual recontributes the distribution to the same eligible retirement plan in the same year. The Form 1099-R may report the distribution under code 2 for "Early distribution, exception applies" if the individual has certified that he or she is qualified and the plan administrator has amended the plan to accommodate this. The distribution may also be reported as code 1 for "Early distribution, no known exception" if the plan has no knowledge of the type of withdrawal or has not amended the plan to accommodate these distributions. It is ultimately up to the individual to report the income correctly on his or her personal tax return.
Employers and administrators have the option of choosing how, or if, they will amend their plans to adopt the rules of Section 2202 of the CARES Act. Employers may adopt the provisions piecemeal and may provide for COVID-19 distributions but not make changes to their loan provisions or repayment terms. Even if an employer does not treat a distribution as COVID-19-related, qualified individuals may treat the distribution as such on their individual tax return if they qualify. Individuals are not required to treat the distribution on their personal tax return in the same manner as the plan administrator reports to them on Form 1099-R. Once again, the burden of proof falls on the individual.
Tip: The plan administrator is not required to withhold 20% of a COVID-19-related distribution, as is usually required under Sec. 3405(c)(1). The distribution is subject to voluntary withholding requirements, if the individual chooses.
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. A college professor once advised the author and her classmates to maximize retirement contributions after graduation, to the point of maintaining the same financial standard of living through their 20s and 30s as they had normalized in college. While this is an extreme example, the principle of creating wealth through aggressively saving for retirement can be a very successful strategy. By withdrawing early, the individual loses not just the current value of the withdrawal but its future value, which can be very significant if an individual is young and has many years of compounding, tax-advantageous growth available.
While the stock market remained high as of this writing, if it trends downward, an individual withdrawing on the decline would be essentially locking in losses. There is no predicting future market conditions, so even if the individual intends to recontribute the funds, significant appreciation may be missed.
Another concern to keep in mind with 401(k) loans is that they are often required to be paid back quickly once individuals leave their employer either voluntarily or involuntarily. Loans that remain unpaid become taxable distributions, potentially subject to the 10% early-withdrawal penalty. It is especially important to consider job security during COVID-19 if considering a 401(k) loan and the tax implications if a loss of employment occurs. Not all plans offer 401(k) loans, and distributions are still at the employer's discretion, so individuals should consult with their employers on specifics before considering a loan or withdrawal.
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. If a withdrawal is made, it is advisable to minimize the amount and only take what is absolutely necessary, with the intention of recontributing within three years — and the sooner the better.
Please refer to Notice 2020-50 and IRS News Release IR-2020-124 for further details of the CARES Act rules for COVID-19-related distributions and loans.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or firstname.lastname@example.org.
All contributors are members of SingerLewak LLP.