Congress passed several relief bills to ease the financial burdens on struggling American workers during the pandemic. A provision of The Coronavirus Aid, Relief, and Economic Security Act allowed workers of any age to withdraw up to $100,000 penalty-free from their company-sponsored 401(k) plan or individual retirement account in 2020. Normally a withdrawal from a 401(k) or IRA before age 59 1/2 would incur a 10% early withdrawal penalty, but the CARES Act waived this penalty for 2020. Income tax is still due on the withdrawal, but there are several options to delay or minimize this tax bill.
“A lot of people were laid off or had their hours cut or their businesses shut,” says Beau Henderson, lead retirement planning specialist with RichLife Advisors in Gainesville, Georgia. “A lot of people took distributions. Many didn’t consider rules. The rules are that it will be a taxable distribution.”
Consider these CARES Act retirement withdrawal rules:
— Penalties are waived, but not the taxes.
— You can spread the tax bill over three years.
— Take advantage of the three-year repayment window.
— If you pay the taxes and then return the money to your account later, you can file an amended tax return.
— If you suffered a reduction or loss in income in 2020, it might be best to pay the taxes now.
Penalties Were Waived, But Not the Taxes
The CARES Act permitted emergency retirement account withdrawals for people coping with a health, financial or child care issue due to the coronavirus pandemic. The legislation allowed people to take distributions of up to $100,000 from their 401(k) accounts or IRAs without having to pay the normal 10% penalty in 2020, even if they were younger than age 59 1/2. However, the distribution is considered ordinary income for tax purposes and will increase your tax liability. The law allows you to stretch the taxes due on a 2020 retirement account withdrawal over three years.
[See: 12 Ways to Avoid the IRA Early Withdrawal Penalty.]You Can Spread the Tax Bill Over Three Years
Income tax is due on emergency withdrawals from 401(k)s and IRAs for coronavirus costs in 2020. Usually you need to pay income tax on a retirement account withdrawal in the year you take the distribution. However, the CARES Act gives you three years to pay the tax bill, beginning in the year the distribution was taken. For example, if you took a $9,000 coronavirus-related distribution in 2020, you could opt to report $3,000 in income on your 2020, 2021 and 2022 tax returns. Alternatively, you could elect to report the entire distribution as 2020 income.
Take Advantage of the Three-Year Repayment Window
You can avoid paying taxes on your CARES Act retirement withdrawal if you are able to put the money back in the account within three years of the distribution. If you are short on cash, you can take your time and repay the money next year or the year after. For example, if you withdrew $30,000, you could repay $10,000 a year for 2020, 2021 and 2022, or you can repay all $30,000 by year three. You can use any repayment schedule, as long as all the taxes are paid or the money is returned to your retirement account by year three.
“The three-year option is a pretty good window,” says Ed Slott, a certified public accountant and author of “The New Retirement Savings Time Bomb.” “Hopefully your finances came around and improved from last year. If things don’t turn around, you have until the last day of year three.”
[See: How to Pay Less Tax on Retirement Account Withdrawals.]You May Need to File an Amended Tax Return
If you pay the taxes on your retirement account withdrawal and then return the money to your account later, you can file an amended tax return. As long as you get the money back into your account by 2022, you can file an amended return and get the taxes you paid returned to you. “If you pay back the money in the next three years, you can file an amended return and recoup your tax,” Slott says.
Slott advises putting the money back in your retirement account as soon as you can so your retirement savings has more time to grow. “You will eliminate the tax bill and build back up your retirement savings,” Slott says.
[Read: How Much Should You Contribute to a 401(k)?]It Might Be Best to Pay the Taxes Now
If you were affected by the pandemic and lost your job or had a reduction in income, it might be to your advantage to take the tax hit this year when your income is lower. For example, if your regular annual salary is $60,000, but you were laid off in March and did not receive a salary for the rest of the year, you may have dropped into a lower tax bracket. If you withdrew $15,000 from your 401(k), you may be able to pay a 12% tax rate on that money instead of the 22% you might pay in a higher earning year. However, if you are able to put the money back in the account within three years, you can avoid the tax bill altogether.
