When COVID-19 placed the country into a state of lockdown, financial difficulties became a reality for many. To assist in lessening the financial burden, the Federal Government passed the Coronavirus Aid, Relief, and Economic Securities Act (CARES). Within this legislation, two specific changes regarding qualified retirement savings were of great impact for the individual taxpayer. It is important to note that the legislation discussed below expired on December 31, 2020, but will have an impact on the 2020 tax return filed this year, as well as tax planning for subsequent years.
The first major item enacted upon retirement saving plans was the opportunity for individuals to waive required minimum distributions (RMD). Prior to the CARES Act, owners of retirement accounts over the age of 72 were required to take a minimum distribution from their retirement savings, which are then taxable at the individual’s income tax rate. However, in late March 2020, the stimulus package allowed individuals to elect to suspend RMDs.
The main purpose was to provide tax relief from mandatory withdrawals for those that could afford not to pull money from their retirement savings. Thus, upon preparing 2020 tax returns, we expect to see smaller tax bills or larger refunds for taxpayers who chose to suspend their RMD in 2020.
Secondly, the CARES Act allowed 401(k) plan participants to withdraw funds from that retirement account without incurring an additional 10% tax. To qualify for this coronavirus-related distribution, the distribution must have been taken between January 1 and December 31, 2020. In addition, the individual must certify that they are 1) diagnosed with COVID-19, 2) have a spouse or dependent who has been diagnosed with COVID-19, or 3) have experienced adverse financial consequences as a result of quarantine, loss of work, or unable to work due to lack of childcare. Prior to this legislation, individuals under the age of 59½ who withdrew from their retirement plan were subject to an additional 10% tax and potential penalties.
It is important to note that coronavirus-related distributions must be repaid over three years from the year of receipt. Once repaid, the distributions are treated as rollover distributions. If the distributions remain unpaid after this time, additional taxes and penalties may be assessed.
Recipients of a coronavirus-related distribution will receive a Form 1099-R to be reported on their 2020 Individual tax return. These recipients are required to file Form 8915-E to report repayments and to determine the amount of the distribution includable as income for the year. Know that if you claim the distribution as income on your tax return and complete repayment of the loan within the three-year timeframe, you can file an amended return to be refunded the taxes you have paid on the distribution.
Individuals will either claim the entire distribution in the year received (2020) or claim the distribution over the course of three years. Strategically spreading the distribution over three years could help lower your tax burden. However, different scenarios call for different strategies.
For example, someone with significantly less income in 2020 may have entered a lower tax bracket. For this person, it might make the most sense to include the entire distribution as income in 2020 and be taxed at a lower rate.
In another instance, someone could have had to pull funds from retirement savings in 2020 but believes they can repay the amount in 2021 before the three years are up. This person could elect to spread out the distribution so that less tax is applied to their 2020 return. When they repay their savings in full in the year 2021, an amended 2020 tax return is filed to recoup the taxes associated with the distribution. Ultimately, this is up to each individual’s discretion and ability to pay back the distribution within the required timeframe.
There are many considerations that go into making the right decision for your situation. If you find yourself questioning what strategy makes the most sense for you given the associated tax implications, please contact a PYA executive below at (800) 270-9629.