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If you ended up tapping your nest egg due to Covid last year, don’t forget the taxman.
Most people did not take an early distribution from qualified retirement accounts — i.e., a 401(k) or individual retirement account — as permitted under temporary rules for last year, according to plan providers such as Fidelity and Vanguard. However, those who did are required to include at least a portion of taxes due on their 2020 return. And, depending on the tax form you received, you may need to take extra steps to may sure you pay no penalty.
“Probably the most challenging thing will be how the distribution was reported, and making sure you get the benefit and are not penalized,” said April Walker, lead manager for tax practice & ethics for the American Institute of CPAs.
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The CARES Act, signed into law last March by then-President Donald Trump, allowed individuals to withdraw up to $100,000 from their retirement account without paying the usual 10% tax penalty if they were under age 59½ — as long as the justification for the distribution was Covid-related. Those reasons could include things like you or your spouse being diagnosed with Covid, getting laid off from your job or working fewer hours.
Of course, the legislation didn’t pardon the taxes due. Here’s what to know.
The rules
First, it’s important to remember that when it comes to traditional 401(k) plans and IRAs (Roth versions have different rules), your generally pay no taxes on your contributions.
Upon withdrawal, however, you have to report the income and pay taxes on it. This is the case even though the CARES Act eliminates the 10% early-withdrawal penalty.
While the temporary rules allow you to spread the distribution across three years, you need to account for at least one-third of the taxes due on that amount on your 2020 return, Walker said.
If you happen to repay the withdrawal amount within the three-year timeframe — which the CARES Act also allows — you would have to file amended tax returns to get back what you paid to Uncle Sam.
The forms
You should receive a Form 1099-R that shows the amount you withdrew from your eligible retirement account. Remember, the IRS receives a copy, as well.
On the form, there should be a distribution code in Box 7. If the code listed is “2,” it signifies that the amount you received in 2020 from your plan was for a qualified reason under the Cares Act, Walker said.
If there is a “1” in the code box, however, you’ll need to fill out a Form 8915-E to certify that your distribution should qualify under the CARES Act, she said.
“On the form itself, it asks what the distribution was for,” she said.
Form 8915-E is generally for disaster-related distributions and allows you to report the early withdrawal over three years.
It’s also worth noting there’s a chance that use of this form could pique interest from the IRS, Walker said.
“It’s a possibility that it might generate correspondence that might say ‘tell us more about why you meet an exception,'” Walker said.
That generally would require providing the IRS with proof that the distribution qualified.
2020 RMDs may qualify
The CARES Act also eliminated required minimum distributions for 2020 and allowed anyone who wanted to reverse an already-withdrawn RMD last year to do so. Those RMDs, which are yearly amounts that must be withdrawn from your retirement accounts starting at age 72, are back in effect for 2021.
If you happen to have taken an RMD in 2020 and did not put the money back, it’s worth seeing if the withdrawal would qualify as under the CARES Act as a Covid-related distribution, Walker said.
“It could be that you got the RMD and after the fact, you determine you qualify,” she said.
The benefit would be the ability to spread that income over three years (and the taxes due).
