Take a retirement plan distribution in 2020? You might get Special Treatment

Looking at markets and the economy today, it’s remarkable how different things feel than they did one year ago. Hope surrounding widespread distribution of COVID-19 vaccines and piles of fiscal and monetary stimulus have many economists projecting some of the most significant growth in 2021 that we’ve seen in decades.  By contrast, the spring of 2020 was filled with dire economic projections of global depressions and economic fallout for years into the future.

Not surprisingly, many people sought out financial measures to cushion the blow.  People who lost jobs in the economic shutdown found that they had to wait weeks and months for unemployment assistance to arrive.  Even those who continued to have their income sources available found the need to cushion their bank accounts under the specter of darker days that lie ahead.  For many people, this meant taking distributions from 401k and IRA accounts.

In any normal year, a distribution of tax-deferred money from a retirement account is taxable in the year it’s distributed.  Additionally, distributions taken prior to age 59 ½ (with some exceptions) are subject to additional taxation, usually 10%.

Under the CARES act, however, an exception was put in place that may provide people with more flexibility and possibly less taxation on distributions from these plans.  The specific provisions apply to a newly defined item called a “Coronavirus Related Distribution (CRD)”.  Distributions that fall into this category, up to an aggregate amount of $100,000, taken between January 1, 2020 and December 30, 2020 can receive three specific kinds of special treatment.

CRD Special Treatment 1: Spreading income out
As I mentioned above, distributions from retirement plans are generally taxed as income in the year they are taken.  Distributions that are considered Coronavirus-Related, however can be spread over 3 years.

Example:  Gary took a distribution from his IRA of $30,000 in January of 2020.  He determines he would be eligible for a CRD.  He can report $10,000 of that distribution as income in 2020, another $10,000 in 2021 and finally another $10,000 in 2022.

Assuming adverse financial conditions require someone to take such a distribution, being able to spread taxation on the distribution can be very helpful, particularly if conditions for the taxpayer improve over the coming years.

The 3-year tax treatment is not required – and someone who took a distribution from their IRA or 401(k) in 2020 to cover lost income might consider having it ALL treated as a 2020 distribution for tax purposes, particularly if they regained employment income in future years.   Taking it all in a year when income was lower may reduce the marginal tax rate paid.

CRD Special Treatment 2: No required withholding
Distributions from qualified plans like 401k generally require 20% federal tax withholding.  It’s not helpful for someone taking an emergency distribution to have to withhold that much, especially if they may be able to spread taxation over 3 years.  As such, plan administrators distributing money for CRDs did not have to withhold the federal tax on these distributions.

CRD Special Treatment 3: No Early Withdrawal Penalty
Coronavirus Related Distributions are not subject to the normal 10% penalty for taxpayers who take distributions prior to age 59 ½.  In our example above, Gary would not have to pay the 10% extra tax, even if he was 30 years old in 2020.

CRD Special Treatment 4: Payback is a Benefit
A final exception to the rules lies in paying back a Coronavirus-Related distribution.  Usually if you take money out of an IRA or qualified plan, it needs to be returned within 60 days to be considered an ‘indirect rollover’.  These can only be done once in a twelve-month period.  CRDs, however, can be paid back any time in the 3-year period covering 2020, 2021 and 2022.  Not only does this allow for more flexibility from a tax standpoint, it can help people to ‘reset’ the damage the early withdrawal did to their retirement plans.

Example: Vicki took $60,000 from her IRA in 2020.  She opted for the three-year tax treatment, and paid income taxes on $20,000 from the distribution on her 2020 return and on another $20,000 on her 2021 return.  In 2022, she received an inheritance and decided to pay BACK her CRD distribution of $60,000.  She will not owe the taxes on the 2022 portion which would have been $20,000.  Also, she can amend her 2020 and 2021 return to be refunded taxes she had paid on the other $40,000.

CRD Definition.
So, what exactly DOES qualify a distribution as a CRD?  That answer isn’t tremendously clear.  The IRS lists some specific items that would qualify a taxpayer to take distributions, including if they had a COVID-19 diagnosis, or within their household, or if they were furloughed, laid off or unable to work because of COVID.   

It’s interesting, however, that distributions can qualify back to January 1, 2020, when arguably no one would have fallen into these categories.  The IRS guidance specifically states that further guidance may be issued expanding the list of factors that would qualify an individual for CRDs.  If you have a question about whether your distributions in 2020 can qualify, first get an opinion from your tax professional, and then work with your advisor to determine whether you benefit from the CRD provisions.

If you do qualify, there is a special form which only a couple weeks ago became available in final form from the IRS.  You can use form 8915-E to report a CRD and to choose tax treatment.

2020 was, indeed, a year of huge uncertainty and upheaval.  CRDs are one of a number of ways the US Government has blunted some of the impact.  Use this provision if you can!