No 10% tax penalty up to 100K Distribution from my IRA/401(k)/403(b) in 2020? Why?

Author: Andrew Lee About 7 minutes read.

DISCLAIMER: Author is not a tax advisor nor tax professional. All materials and references below are interpreted as-is and is only used for general information purposes and not for tax advise. Content is also time sensitive and could be out of date. Please consult with a qualified tax professional before following any information here.

Note: IRS Publications and Guidelines are subject to changes. The notes and information here were based on IRS Publications from 2019 and 2020 when this article was written.

After March 27th, 2020, you might hear a lot of people talking about withdrawing/obtaining up to $100,000 distribution from their combined eligible tax-exempt retirement plans (e.g. Section 401(k)/403(b) or IRAs and the total distribution from multiple qualified accounts cannot exceed $100,000) or special rollover rules on such distribution.

But what exactly are those, and can you do that before reaching the IRS definition of retirement age of 59.5 or the exceptions? In fact, the one you heard from friends or medias on or after March 27th, 2020 are likely from The Coronavirus Aid, Relief, and Economic Security (CARES) Act Section 2202 regarding the coronavirus-related distribution in this year 2020. It says,

“(Sec. 2202) This section permits penalty-free coronavirus-related distributions from tax-exempt retirement plans up to $100,000 in a taxable year. A coronavirus-related distribution is defined as any distributions from an eligible retirement plan made on or after January 1, 2020, and before December 31, 2020, to an individual who is (1) diagnosed with the virus SARS-CoV-2, (2) whose spouse or dependent is diagnosed with such virus or disease, or (3) who experienced adverse financial consequences from being quarantined, furloughed, or laid off from work due to such virus or disease.”

Besides, the Section 2202 in CARES Act is not the first that allows distribution for qualified individuals. Back in 2005, there was the IRS Notice 2005-92 (regarding Katrina Emergency Tax Relief Act 2005) that had the provisions that applied to the victims of Hurricane Katrina. Shall we always assume such provisions will occur for hardship or catastrophic events? Or shall we prepare ourselves better for such incidents and events? Perhaps, I should think about it and take it seriously since I am more concerned? Since we do not need to worry about the “10-percent additional tax on early distributions from qualified retirement plans”, what about the tax implication? Fortunately, IRS has published a guideline.

If you are a qualified individual under CARES Act Section 2202, when you apply for this distribution from your qualified 401(k)/403(b)/IRA account (consult with your retirement plan provider and tax professional if you are not sure), the combined distribution amount, by default, is evenly distributed across 3 years - 2020, 2021, 2022 as your taxable income without the additional 10% penalty on this distribution. If you repay the full distribution amount you took to a qualified retirement plan by the end of 2020, no tax implication will occur on your 2020 tax filing (however, you still need to file Form 1099-R). Otherwise, the distribution amount is either evenly distributed to your gross income across 3 years in 2020, 2021, and 2022, or if you elect to put the entire distribution in your 2020 gross income. Besides, a quick reminder, when this distribution is taken out, make sure you look for Form 1099-R since you will need this for your tax filing and also keep a copy of all the paperwork/application from your employer sponsored 401(k) or IRA provider.

For example, a qualified individual under CARES Act Section 2202, coronavirus-related distribution $30,000 in 2020, simplified tax scenario with 1 earned income after all deductibles and qualified contribution to a retirement plan, etc. (e.g. standard deduction $12,400 for 2020 and pre-tax contribution, etc.) in 2020-2022 for the next 3 years, it may look like this depending on how you elect the year for this $30,000 distribution:

Different scenarios on how distributions is elected and repaid to a qualified retirement plan based on gross income

The $30,000 distribution is subject to federal income tax (use IRS Form 8915-E which should be available before end of 2020), and also subject to California State income tax if your residency is in California.

According to IRS Notice 2005-92 Section 4.B,

“All Katrina distributions received in a taxable year must be treated consistently (either all distributions are included in income over a 3-year period or all distributions are included in income in the current year). If a qualified individual uses the 3-year ratable income inclusion method, such method cannot be changed after the timely filing of the individual’s tax return (including extensions) for the year of the distribution.”

Once you elect for one of the method (income ratably 3-year period OR all distribution in 2020), you cannot change it. If you elect for the taxable portion of the distribution in income ratably over the 3-year period, you do not need to include the last portion of the distribution in your 2022 gross income if you repay the last portion in 2022. Once you repay the entire distribution to a qualified retirement plan, you will need to file a tax amendment for the years 2020 and 2021 where you included the distribution as part of your gross income.

For those that are thinking to re-contribute this distribution to another IRA account (rollover), I found this in IRS Notice 2005-92 Section 4 and it says,

“a qualified individual is permitted to recontribute any portion of a Katrina distribution that is eligible for tax-free rollover treatment to an eligible retirement plan within 3 years from the day after the date of the distribution, and the recontribution will be treated as if it were paid in a direct rollover to an eligible retirement plan”

If this is something you are contemplating, consult with a qualified tax professional and evaluate your situation before action.

When I was exposed to these information in March 2020, it misled me to think about withdrawing my retirement investment, hence, spending time to write this article to reflect my thoughts. If you withdraw from a retirement plan, it not only complicates the tax for that year, but also hampers your retirement schedule and income. In my opinion, you are borrowing from your future and time is your enemy here. You can read my other post here that talks about how critical is time pertaining to your retirement. When people look into hardship distribution or 401k loans or refinancing or Home Equity Line of Credit (HELOC) and more, you do want to understand the pros and cons for each scenarios and their tax consequences, loan fees and interest rates, and payback schedules. Do your due-diligence. I found a very good article that talks about 401(k) loan which is worth reading. Keep in mind, your employer sponsored 401(k) policy is NOT the same as your IRA account. Before touching your retirement fund, you may also want to review your financial portfolios for all other alternatives including, but not limited to, using your emergency fund if applicable, or liquidating assets if time allows (e.g. personal properties - spare car, computers, TVs, camera, etc. or other properties), or other investment like Certificate Deposit, Stocks, Bonds, or policy loan from Cash Value Life Insurance (if you plan to keep the policy enforced, no lapse or surrender, do consult with your life insurance agent for the options), and always consult with a qualified tax-advisors or professionals before taking actions.

Supplemental Information

10% additional tax calculation

IRC Section 72(t)(1) defines the 10% additional tax on early distributions from qualified retirement plans as “If any taxpayer receives any amount from a qualified retirement plan (as defined in section 4974(c)), the taxpayer’s tax under this chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income.”. A simple explanation is that if you took out $30,000, you will need to pay the 10% tax $3,000, and $30,000 is considered your gross income. So if your effective tax rate is 20%, the tax you may owe is:

$30,000 x 20% + $3,000 = $6,000 + $3,000 = $9,000
It is NOT $30,000 x (1 + 10%) x 20% = $6,600 which is a big difference.

References

Public Law No: 116-136 (03/27/2020) The Coronavirus Aid, Relief, and Economic Security (CARES) Act - https://www.congress.gov/bill/116th-congress/house-bill/748
CARES Act - https://home.treasury.gov/policy-issues/cares State of California FTB COVID-19 frequently asked questions for tax relief and assistance https://www.ftb.ca.gov/about-ftb/newsroom/covid-19/help-with-covid-19.html#COVID-19-Economic-impact-payments-CARES-Act Section 2202 CARES Act IRS News - https://www.irs.gov/newsroom/coronavirus-related-relief-for-retirement-plans-and-iras-questions-and-answers IRC Section Section 72(t)(1) - https://www.law.cornell.edu/uscode/text/26/72 Retirement Topics - Exceptions to Tax on Early Distribution - https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions Rollovers of Retirement Plan and IRA Distributions - https://www.irs.gov/retirement-plans/plan-participant-employee/rollovers-of-retirement-plan-and-ira-distributions Do’s and Don’ts of Hardship Distributions - https://www.irs.gov/retirement-plans/dos-and-donts-of-hardship-distributions 401k loans, the good, the bad, the ugly - https://thecollegeinvestor.com/33800/401k-loans/ Get free tax advice - https://www.debt.com/money-tips/get-free-tax-advice/