You Took Coronavirus-Related IRA Money Last Year: What Now?
Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo
If you’re a traditional IRA owner who was adversely affected by the COVID-19 pandemic last year (2020), you may have been eligible to take a tax-favored coronavirus-related distribution from a traditional IRA.
If so, that privilege was thanks to the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).
In this analysis, we will call these tax-favored traditional IRA distributions “CVDs.” Elsewhere, you may see them called “CRDs.”
Whatever they may be called, this analysis explains how to get the best federal income tax results. But ﬁrst, let’s cover the necessary background information on CVDs.
If you were eligible, you could have taken one or more CVDs from one or more traditional IRAs in 2020, up to a combined limit of $100,000.
You can re-contribute the CVD amount(s) back into one or more traditional IRAs within three years of the withdrawal date(s). You treat each withdrawal and later recontribution within the three-year window as a federal-income-tax- free IRA rollover transaction. That’s the tax advantage.
The non-tax advantage is that there are no restrictions on how you can use CVD funds. You can use the money to pay bills and recontribute later—within the three-year window—when your ﬁnancial situation permits. You can help out your adult kids now and recontribute later.
So, a CVD can be a useful tax-favored cash-management tool.
Key point: The favorable tax treatment applies equally to CVDs taken from garden-variety traditional IRAs, SEP- IRAs, and SIMPLE-IRAs.
Original Eligibility Rule
According to the statutory language in the CARES Act, a CVD is a distribution of up to $100,000 from an eligible retirement plan, including an IRA, that is made between January 1, 2020, and December 31, 2020, to an individual
- Who was diagnosed with COVID-19 by a test approved by the CDC; whose spouse or dependent (generally a qualifying child or relative who receives more than half of his or her support from you) was diagnosed with COVID-19 by such a test;
- Who experienced adverse financial consequences as a result of being quarantined, furloughed, or laid off, or having work hours reduced, due to COVID-19;
- Who was unable to work because of a lack of childcare due to COVID-19 and experienced adverse financial consequences as a result;
- Who owned or operated a business that closed or had operating hours reduced due to COVID-19 and experienced adverse financial consequences as a result; or
- Who experienced adverse financial consequences due to other COVID-19-related factors specified by IRS guidance.
Liberalized Eligibility Rule
IRS Notice 2020-50 expanded the statutory list of individuals who were eligible to receive CVDs to include those who, in 2020, met any of the following descriptions:
- The individual had a reduction in pay or a reduction in self-employment income due to COVID-19.
- The individual had a job offer rescinded or the start date for a job delayed due to COVID-19.
- The individual’s spouse or a member of the individual’s household (1) was quarantined, furloughed, or laid off due to COVID-19, or (2) had work hours reduced due to COVID-19, or (3) was unable to work because of a lack of childcare due to COVID-19, or (4) had a reduction in pay or in self-employment income due to COVID-19, or (5) had a job offer rescinded or the start date for a job delayed due to COVID-19.
- The individual, or the individual’s spouse or a member of the individual’s household, owned or operated a business that closed or reduced hours due to COVID-19.
Key point: A member of an individual’s household is someone who shares the individual’s principal residence.
Notice 2020-50 also clariﬁed that the CVD privilege was not limited to amounts withdrawn to meet ﬁnancial needs arising from COVID-19.
For example, individuals who were eligible to receive CVDs due to experiencing adverse ﬁnancial consequences, as described above, could receive CVDs without regard to any actual need for funds. Furthermore, the amounts of CVDs received by such eligible individuals need not correspond to the extent of any adverse ﬁnancial consequences experienced by such individuals.
The Downside: Inconvenient Interim Tax Consequences
It’s true that if you re-contribute a CVD amount within the three-year window, the ultimate result is the same as a federal-income-tax-free IRA rollover.
Unfortunately, you must put up with some potentially awkward interim tax consequences before you arrive at the tax-free-rollover-equivalent outcome. The interim tax consequences can diminish the cash-management advantages of the CVD deal, and they require ﬁling amended returns to gain federal-income-tax-free treatment.
If you take several CVDs (up to the $100,000 combined limit), the interim tax consequences apply separately to each CVD. But let’s keep things as simple as possible to make the following examples easier to understand.
- Example 1: Re-contribute in 2023. You were eligible for the CVD privilege. You took one $100,000 CVD from your traditional IRA in 2020. The $100,000 would be fully taxable under the regular federal income tax rules for traditional IRA withdrawals. (If you’ve made nondeductible traditional IRA contributions over the years, the withdrawal would not be 100 percent taxable, but we are keeping things simple here.)
The usual way to line up federal-income-tax-free treatment for your CVD involves spreading the $100,000 of taxable income that you would report under the regular tax rules equally over 2020, 2021, and 2022. So, you would report $33,333.33 on your 2020 Form 1040. Ditto for 2021 and 2022. This treatment is called the “three-year ratable income inclusion method.”
After re-contributing the entire $100,000 sometime in 2023, before the three-year window closes, you ﬁle amended returns for 2020, 2021, and 2022 and get back the interim federal income tax hits for those years. At the end of the day, the CVD is federal-income-tax-free, as advertised. But you had to jump through some hoops to get there.
- Example 2: Re-contribute before 2023. You have the necessary cash, so you choose not to wait until sometime in 2023 to re-contribute the CVD amount. For instance, if you use the ratable income inclusion method and then recontribute the entire $100,000 in 2022, there won’t be any interim tax hit for that year. You would generally ﬁle amended returns for 2020 and 2021 to get back the interim tax hits for those years. Once again, the CVD is federal-income-tax-free at the end of the day. Once again, you had to jump through some hoops.
Key point: See Examples 6 and 7 below for speciﬁc scenarios.
- Example 3: Report all CVD income on your 2020 return. You also have the option of electing to report the entire $100,000 of CVD income on your 2020 Form 1040, which you may or may not have ﬁled yet. If you then re-contribute all or part of the $100,000 within the three-year window, and you’ve already ﬁled your 2020 Form 1040, you must ﬁle an amended 2020 return to get back all or part of the tax hit for that year.
See Examples 4 and 5 below.
Potential Negative Impact of Higher Tax Rates
As the preceding examples illustrate, you can potentially have interim tax hits in 2020, 2021, and 2022, even if you re-contribute the entire CVD amount within the three-year window. Depending on political developments, federal income tax rates could be higher after 2021 and maybe even for 2021, if a retroactive rate increase is enacted. A retroactive rate increase looks fairly unlikely right now, but you never know.
If a rate increase happens, the interim tax hits under the three-year ratable income inclusion method will be that much higher. As long as you re-contribute the entire CVD amount within the three-year window, you’ll eventually get back all the interim tax hits, but getting them back might not be much fun.
Tax Results If You Don’t Re-contribute Within the Three-Year Window
You always have the option of simply keeping all or part of your CVD money. You’ll have taxable income from the CVD amount that you don’t re-contribute. As explained in the preceding examples, you can spread the taxable income from the CVD equally over three years under the three-year ratable income inclusion method, or you can elect to report all the CVD income on your 2020 Form 1040.
If it later turns out that you have enough cash to re-contribute within the three-year window, you can always decide to re-contribute and recover any related federal income tax hit(s).
Good News: Regardless of what you choose to do with your CVD, you won’t owe the dreaded 10 percent early withdrawal penalty tax that generally applies to traditional IRA withdrawals taken before age 59 1/2. CVDs are completely exempt from the penalty tax.
IRS Notice 2020-50 clariﬁes that CVDs taken from a SIMPLE-IRA are exempt from the 25 percent early distribution penalty tax that generally applies to SIMPLE-IRA withdrawals taken before age 59 1/2.
More Good News: When you recontribute a CVD amount within the three-year window, it’s deemed to be a direct trustee-to-trustee transfer that’s exempt from the one-IRA-rollover-per-year limitation.
Bad News: According to IRS Notice 2020-50, beneﬁciaries of inherited IRAs can receive CVDs as long as they are eligible individuals,
- They can follow the three-year ratable inclusion rule to report taxable income from CVDs, and
- Their CVDs are exempt from the 10 percent early distribution penalty tax.
- But only an IRA CVD that is otherwise eligible for tax-free rollover treatment can be re-contributed. Therefore, CVDs received by beneﬁciaries of inherited IRAs (other than the surviving spouse of the IRA owner) cannot be re-contributed. So, no tax-free-rollover-equivalent deal for those folks.
Tax Reporting and Procedural Issues
Notice 2020-50 stipulates the following:
- Both you and the IRS will receive a 2020 Form 1099-R that reports the amount of your CVD, even if you re-contributed the entire amount to the same IRA last year.
- IRA trustees and custodians can accept re-contributions of CVD amounts if they can reasonably conclude that the recontribution is eligible for tax-free-rollover-equivalent treatment under the CARES Act rules and that the recontribution is made in accordance with the rules set forth in Notice 2020-50.
- Trustees and custodians can rely on your certification that you were eligible for the CVD privilege, including the right to make tax-free-rollover-equivalent re-contributions, unless the trustee or custodian has actual knowledge to the contrary.
- You become entitled to the favorable CVD tax treatment explained in this analysis by reporting your CVD on Form 1040 (if filing Form 1040 is required) and on Form 8915-E, Qualified 2020 Disaster Retirement Plan Distributions and Repayments (Use for Coronavirus-Related Distributions).
- Also use Form 8915-E to report any CVD re-contributions that you made during the year and to determine the amount of CVD taxable income that you must report for the year if any.
You must treat all CVDs received in 2020 the same way. Either all must be taxed using the three-year ratable income inclusion method or all must be reported as income on your 2020 Form 1040. You cannot make or change this election to report all CVD income on your 2020 Form 1040 after the date you timely ﬁle your 2020 Form 1040, including extensions.
If you have already ﬁled your tax return for 2020, you can make a change to your CVD treatment by ﬁling a superseding return.
How to Handle Recontributions If You Choose to Report All CVD Income in 2020
You make the election to report all CVD income in 2020 by checking the box on Line 17 of Form 8915-E and then reporting the entire amount of your CVD(s) as income on your 2020 Form 1040.
If you then re-contribute all or part of the CVD amount on or before the due date of your 2020 Form 1040 (including any extension), don’t report the re-contributed amount as gross income on your 2020 return.
If instead, you re-contribute all or part of the CVD amount after the due date of your 2020 Form 1040 (including any extension), you must ﬁle an amended 2020 return to remove the re-contributed amount from your 2020 gross income and thereby recover the related 2020 tax hit. The amended return must include Form 8915-E to report the re-contribution. See Examples 4 and 5 below.
- Example 4: Last year, you took a $65,000 CVD from your traditional IRA. On March 31, 2021, you re-contributed the entire $65,000. On April 10, 2021, you ﬁled your 2020 Form 1040 and reported the re-contribution on Form 8915-E included with the return. Since you re-contributed the entire CVD amount before the due date for ﬁling your 2020 return, you properly reported no CVD income on that return.
- Example 5: Last year, you took a $90,000 CVD from your traditional IRA. You extended the due date for your 2020 Form 1040 to October 15, 2021. You re-contribute the entire $90,000 on October 14, 2021. Since you re-contribute the entire CVD amount by the extended due date for ﬁling your 2020 return, don’t report any of the $90,000 as gross income on that return. Include Form 8915-E with the return.
Variation. Same as above except you don’t get around to re-contributing the $90,000 until January 2022. Since you did not recontribute by the extended due date for ﬁling your 2020 Form 1040, you paid taxes on the $90,000. To recover the taxes, you need to ﬁle an amended 2020 return to report the contribution.
How to Handle Re-contributions If You Use the Three-Year Ratable Income Inclusion Method
As mentioned earlier, you can spread the income from CVDs equally over three years, starting with 2020. If you then re-contribute any CVD amount within the three-year window before the Form 1040 due date for the year of the re-contribution (including any extension), the amount of the re-contribution reduces the ratable income inclusion amount that’s reported on that year’s return. See Examples 6 and 7 below.
- Example 6: Last year, you took a $90,000 CVD from your traditional IRA. You decide to use the three-year ratable income inclusion method to report the CVD income: $30,000 in 2020, $30,000 in 2021, and $30,000 in 2022.
On April 10, 2022, you re-contribute $30,000. You then ﬁle your 2021 Form 1040 on April 15, 2022. The re-contribution reduces the amount that you must report as CVD income for 2021 from $30,000 to zero.
You make no further re-contributions within the three-year window. So, when all is said and done, you will have reported $30,000 of taxable income for 2020, zero for 2021, and $30,000 for 2022.
- Example 7: Same as Example 6 except this time you re-contribute the $30,000 on August 10, 2022. You don’t extend your 2021 Form 1040, which you ﬁle on April 15, 2022. You must report $30,000 of CVD income on your 2021 Form 1040.
But the re-contribution reduces the amount that must be reported as CVD income for 2022 from $30,000 to zero. So, when all is said and done, you will have reported $30,000 of taxable income for 2020, $30,000 for 2021, and zero for 2022.
What’s the Best CVD Strategy for 2021-2023?
Good question. The interim tax consequences for CVDs are inconvenient at the very least, and they can seriously reduce the cash-management advantage of the CVD privilege. But consider the following strategies:
- If your 2020 taxable income was much lower than usual due to COVID-19 economic fallout, you might have a very manageable federal income tax hit from including the CVD income on your 2020 Form 1040. You’ll have extra cash in hand. Later, you can recover some or all of the 2020 tax hit by re-contributing some or all of the CVD amount within the three-year window and getting the re-contributed amount back into tax-favored IRA status. Or you can just keep all the cash and live with the 2020 tax hit.
- If you had negative 2020 taxable income because of business losses due to COVID-19 economic fallout, reporting all the CVD income on your 2020 Form 1040 could be a very tax-smart move if you can shelter most of or all that income with business losses. You will have extra cash in hand and will owe little or no federal extra income tax for 2020. If you have sufficient cash, later on, you can recontribute all or part of the CVD amount within the three-year window, recover all or part of any 2020 tax hit, and get the re-contributed amount back into tax-favored IRA status.
- If you re-contribute the CVD amount sooner than required, it will mitigate unfavorable interim tax consequences, as illustrated by some of the preceding examples.
Key point: For any CVD amount that was not re-contributed by December 31, 2020, you have until October 15, 2021, to make the decisions that will determine how that amount will be taxed, as long as you extended the deadline for ﬁling your 2020 Form 1040 to October 15, 2021. Or, if you have already ﬁled, you could ﬁle a superseding return.
In the right circumstances, taking advantage of the CVD privilege can be a good, tax-smart ﬁnancial planning strategy. Some “experts” scoff at that statement, because they think taking money out of an IRA before retirement is always a terrible idea. But we stand by the statement.
That said, if you don’t re-contribute CVD amounts by the due date for your 2020 Form 1040, there can be inconvenient interim tax consequences. Or not. It depends on your speciﬁc circumstances.
For any CVD amount that was not re-contributed in 2020, you have until October 15, 2021, to make the decisions that will determine how that amount will be taxed, as long as you extended the deadline for ﬁling your 2020 Form 1040 to October 15, 2021 (or you ﬁle a superseding return).
SIDEBAR: If You Took a CVD from Your Company Retirement Plan
Employer-sponsored retirement plans were allowed (but not required) to issue CVDs to eligible plan participants who requested them.10 If you took a CVD from a company plan, the federal income tax results will usually be similar to those that apply to CVDs taken from IRAs, as explained in this article’s analysis.
Key point: The total amount taken from all company retirement plan accounts in 2020 that you can treat as CVDs cannot exceed $100,000. Apparently, a separate $100,000 limit applies to all IRAs that you own.
If you need any clarification of what this all means and you wish to retain more of what you make and multiply your net worth while remaining tax compliant, contact us at Morris + D’Angelo. This is our Expertise!
Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo
Daniel frequently provides Media Content via Workshops, Podcasts, and Printed Articles on topics like Bitcoin and Cryptocurrency, Wealth Preservation and Planning, Global Banking, and many other high-level financial topics that serve and demonstrate the Value of our Global Network that should be of interest to those who need Private High-Wealth Services.
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