The pandemic we are currently living in has resulted in the breakdown of financial backbone of many, mostly by eating out on the individual savings and emergency funds completely. To cover current expenses, many had to migrate unwillingly to their retirement savings. However, a pre-withdrawal of one’s retirement plan doesn’t come without some disadvantages.
For example, a 59 years old tax payer would face an additional 10% tax on early withdrawal of retirement fund.
As soon as the government identified that accessing retirement savings is a critical back up plan to sail through financial distress during the pandemic, under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, early withdrawals made in 2020 due to COVID-19 hardships were safeguarded against any additional 10% tax under Sec. 72(t) or additional 25% tax on SIMPLE IRAs under Sec. 72(t)(6), given some defined conditions are met.
For the taxpayer to be shielded against the 10% penalty, the distribution must be in sync with 4 requirements as stated below:
1. Distribution made to a Qualified Individual
Under Sec. 2202(a)(4)(A)(ii) of the CARES Act, a qualified individual is anyone who has been diagnosed with the COVID-19 virus by a test approved by the Centers for Disease Control and Prevention or alternatively, has experienced adverse financial consequences due to being quarantined, furloughed, or laid off; having work hours or pay reduced; having been unable to work due to a lack of child care; having owned or operated a business that has been closed; having a reduction in self-employment income; or having a job offer rescinded or a start date delayed.
An individual is also deemed to be qualified in case his or her spouse or a member of his or her direct household has experienced any of the clauses mentioned above. Such a person will not be required to showcase a financial need for funds to avail this provision. An early distribution is allowed for any individual who has experienced any of the adverse financial consequences as listed above.
2. Distribution made from an Eligible Retirement Plan
Any IRA, 401(k), 401(a), any annuity like 403(a) or 403(b), and any governmental deferred compensation plan like 457(b) are considered eligible retirement plans, where distributions are included in a taxpayer’s gross income in the year of distribution. Such distributions can usually be directly rolled over.
3. Distribution made in calendar year 2020
Any such distribution made in the calendar year 2020 will be considered eligible.
4. Distribution must be $100,000 or less in Aggregate
Aggregate distributions eligible for COVID-19 relief should not exceed $100,000 per individual i.e. a single employer or plan administrator cannot disburse in excess of $100,000 as COVID-19 relief to any individual. Although distributions from multiple unrelated plans that exceed $100,000 in aggregate are allowed to an individual, however he can only exclude up to $100,000 from the additional 10% tax.
Once all the stated conditions fall into place, the eligible distributions should be reported as income and hence become subject to income tax, although, there will be no additional tax or a penalty attached with them for early distribution.
As per the CARES Act, individuals can report distributions ratably over three years i.e. any individual who withdraws $30,000 in 2020 can ideally report $10,000 of income in 2020, 2021, and 2022. When an individual is deemed as a qualified individual, he or she can choose to elect out of the three-year ratable income inclusion and alternatively, can include the total amount in the withdrawal year. This is to note that, such a kind of election should be essentially be made by the date the tax return is filed and the individual may not get a chance to alter it later.
Finally, all COVID-19-related distributions should be kept consistent and either reported fully in the tax year of withdrawal, or alternatively, reported ratably over three years.
Hence, much planning is required by the CPAs to assess and decipher the most tax-advantageous strategy for income timing for the individual client.