Are retirement distributions due to coronavirus furlough taxable or subject to the 10% penalty?

Question of the week: Clients took early retirement distributions from IRAs after coronavirus furloughs. Are distributions subject to tax and penalty?

June 17, 2020

Q. Clients took early IRA distributions to help with living expenses after coronavirus furloughs. Will the distributions be taxed and subject to the 10% penalty?

Clients Rick and Elsa each withdrew about $5,000 from their respective IRAs to help with living expenses. Both were furloughed mid-April because of hopefully temporary company shutdowns. Nobody in the family has the coronavirus, but with the sudden loss of both incomes they were struggling to pay their bills. They both think they’ll be recalled this summer but one of them will have to remain home a while, as the daycare for their young children won’t open before the fall. It’s unlikely they’ll be able to roll over any of the money within 60 days and may have to withdraw more. Are Rick’s and Elsa’s IRA withdrawals subject to tax and the 10% penalty. They may have spent some of the money on medical expenses but they’re both in their 30s and no other exceptions seem to apply.

A. A special provision of the CARES Act waves the 10% early withdrawal penalty for coronavirus-related distributions. It also allows taxpayers to recontribute distributions over three years and/or to spread the tax on the distributions over three years.

Under a provision of the CARES Act, your clients’ IRA withdrawals are exempt from the 10% early withdrawal penalty and may be tax-free too depending on what actions they take.

Early withdrawal penalty

Section 2202 of the CARES Act provides that the 10% additional tax (early withdrawal penalty) does not apply to any coronavirus-related distribution. A coronavirus-related distribution is defined as an IRA or retirement plan, such as a 401(k), or 403(b), distribution for up to $100,000 made to a qualified individual on or after January 1, 2020, and before December 31, 2020. A qualified individual is an individual:

  1. Who is diagnosed with COVID-19 by a CDC-approved test,
  2. Whose spouse or dependent is diagnosed with COVID-19,
  3. Who experiences adverse financial consequences because of a COVID-19 related quarantine, furlough, layoff, reduction in work hours, etc.,
  4. Who experiences adverse financial consequences related to the closure or reduction of hours of the individual’s own business because of COVID-19, or
  5. Who is unable to work because of the lack of school or childcare availability for COVID-19 related reasons.

Thus, while Rick and Elsa are not ill, because of COVID-19, their distributions are not subject to the 10% penalty. They have experienced financial difficulties following the two furloughs and one of them may have to remain home to care for their children even when they’re recalled to work.

Recontributions and taxation

Coronavirus-related distributions may be recontributed to an IRA or retirement plan, such as a 401(k) or 403(b), any time during the three-year period beginning the day after the withdrawal. During this period, Rick and Elsa can recontribute the entire amount they each withdrew, or any amount they choose, limited to the original amount withdrawn. Also, they can make one or several recontributions, again, limited in total to their original withdrawals.

Recontributed amounts are not subject to tax. They are treated as if the IRA or retirement plan beneficiary received an eligible rollover contribution and, within 60 days, transferred the amount to an IRA or retirement plan in a direct trustee to trustee transfer.

Any part of the coronavirus-related distribution that is not recontributed is included in taxable income, but not all at once. The distribution is included ratably over the three-year period beginning with the year of withdrawal. This provision allows Rick and Elsa to decide if and how they wish to recontribute the funds. Also, they can elect to opt out of the three year spread and pay tax on the entire distribution this year.

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