Taxpayers under financial duress caused by the pandemic can avoid penalties.
By Celeste Schimmenti, CPA
Unfortunately, the COVID-19 pandemic 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, barring other extenuating circumstances.
Congress recognized that for many, the ability to access retirement savings is a necessary lifeline to financially weather the pandemic. Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, 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 (1) made to a qualified individual, (2) from an eligible retirement plan, (3) between Jan. 1, 2020, and Dec. 31, 2020, and (4) $100,000 or less in aggregate. Here is a look at the four requirements:
Made to a qualified individual: The definition of a qualified individual in Sec. 2202(a)(4)(A)(ii) of the CARES Act is fairly generous. A qualified individual is anyone who has been diagnosed with the COVID-19 virus 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owned or operated a business that has been closed; having a reduction in self-employment income; or having a job offer rescinded or a start date delayed.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.
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.
Made in calendar year 2020: This requirement is straightforward.
Must be $100,000 or less in aggregate: 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.
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 a 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. Additionally, 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.
For a detailed discussion of the issues in this area, see “Tax Clinic: Early Distributions From Retirement Plans Related to COVID-19” in the November 2020 issue of The Tax Adviser.
— Celeste Schimmenti, CPA