Penalties Are Forgiven, Taxes Are Not

If you’re saving for retirement through a qualified retirement plan, you may be aware that the rules for taking early withdrawals have been relaxed this year due to the COVID-19 pandemic. But not everyone who has a retirement account can make an emergency withdrawal; there are rules attached. Moreover, some or all funds withdrawn and not repaid by the end of this year will be required to be recognized as income and subject to tax.

The Coronavirus Aid, Relief and Economic Security (CARES) Act enacted in March 2020 includes provisions that allow retirement savers to take early distributions and loans from their plans – without the usual limitations or penalties – if their income or health has been affected by COVID-19.

These provisions apply to anyone who has a qualified workplace retirement plan, such as a 401(k), 403(b), or 457 plan, or an Individual Retirement Account (IRA), a SEP IRA, or a SIMPLE IRA.

How to qualify

Under the CARES Act, a withdrawal of up to $100,000 from a qualified retirement account may be made during calendar year 2020 by an individual who:

  • Is diagnosed with COVID-19
  • Has a spouse or dependent diagnosed with COVID-19.
  • Has experienced financial consequences as a result of being quarantined, furloughed, laid off or having work hours reduced because of the virus.
  • Is unable to work due to lack of childcare because of COVID-19.

If such a withdrawal is made and paid back by the end of the year, there will be no tax consequences. However, some workplace retirement plans don’t allow rollovers, and repaying the money back into the plan would be considered a rollover. In this case, you would want to “repay” the money by putting it into a separate qualifying IRA outside of the workplace retirement plan.

Tax consequences

An emergency withdrawal from a retirement plan that is not repaid by the end of this year would be taxable at your ordinary income tax rate over the next three years, meaning tax years 2020, 2021 and 2022. This means you would start paying taxes on the withdrawn funds next spring when you file your 2020 income tax returns.

The tax implications are confusing to some retirement plan participants who have heard they may make “penalty-free” emergency withdrawals due to COVID-19. While the CARES Act does waive the normal 10% penalty attached to early withdrawals from retirement plans, it does not waive the income tax liability.

Three-year tax deferral

Another misconception around these retirement plan withdrawals is the belief that the taxpayer has the option to wait three years to recognize the income on the amount of the distribution and thus defer the income tax liability. As stated above, the distributions are generally included in income ratably over three years beginning in the year the distribution is made, though the taxpayer can choose to recognize all the income in year one if they wish.

RMD waiver

For retirement plan participants who are over age 72 and, therefore, subject to Required Minimum Distributions (RMDs), the RMD requirement has been waived for 2020. Hence, if you don’t need the annual payout from your retirement plan to meet living expenses, and you would prefer not to draw down your account while the stock market is down, you may skip the RMD this year.

If you feel you need to tap your retirement account to help meet COVID-19-related expenses, please contact your Adams Brown advisor for guidance.