Filing 2020 Returns: Help for Clients Who Took Early Distributions from IRAs or Qualified Plans

Filing 2020 Returns: Help for Clients Who Took Early Distributions from IRAs or Qualified Plans

This week’s entry is a continuation of my effort to provide you with some last-minute filing tips for those few remaining 2020 returns on extension.

What I want you to remember are the many alternatives recent legislation provided for taxpayers who took early distributions from IRAs or qualified plans. The opportunities provided by these laws can help your client:

1. Avoid early withdrawals penalties.
2. Provide the ability to spread out the recognition of income.
3. Allow for the taxpayer to put the money back (couldn’t help but reference one of my favorite movies, Young Frankenstein).
4. For taxpayers who took qualified plan loans, additional time for repayment is provided as well.

What provisions am I describing?

1. Before 2018, employees who borrowed from their qualified plans and then left employment had only 60 days to reinvest the funds or have the loan treated as an early, deemed distribution subject to taxation and an early withdrawal penalty. Beginning in 2018, the Tax Cuts and Jobs Act (TCJA) increased the time to reinvest the loan proceeds from 60 days to the due date of the tax return for the year of deemed distribution, plus extension.  (Referred to as “loan offset” rules). These rule changes have no relationship to COVID-19 rules which are discussed next.
2. The Families First Coronavirus Response Act (FFCRA), removed the 10% penalty for early distributions from qualified plans for withdrawals up to 100% of an account balance or $100K whichever is less. The $100K limit was also an increase from the previous $50K or 50% of the account balance limit.  This law also introduced the ability to reinvest the early withdrawal within three years and also the ability to include the distribution as income ratably over three years.  The caution to consider here is that these withdrawal provisions were placed into effect for taxpayers who were impacted by disasters and had qualified disaster distributions.  IRS Publication 590-B provides more guidance in this area.
3. The Coronavirus Aid, Relief, and Economic Security Act (CARES) (PL 116-136) basically built off the provisions of the FCAA by including persons impacted by the coronavirus pandemic as being able to avoid the 10% early withdrawal penalty, withdraw up to $100K and have three years to reinvest withdrawals as provided by the FCAA or report the distribution ratably over three years.

In essence, the provisions of the CARES Act provide that the coronavirus rises to the level of a disaster for persons impacted by the pandemic.

Distributions must have occurred after January 1, 2020 and before December 31,2020 for the CARES Act provisions to apply.

If you are concerned as to what degree your client may have been impacted by the coronavirus, here are the rules:

PL 116-136, §§2202(a)(1) and (a)(4)(A)(4):  DEFINITIONS.—For purposes of this subsection— (A) CORONAVIRUS-RELATED DISTRIBUTION.—Except as provided in paragraph (2), the term ‘‘coronavirus-related distribution’’ means any distribution from an eligible retirement plan made— (i) on or after January 1, 2020, and before December 31, 2020, (ii) to an individual—

(I) who is diagnosed with the virus SARS– CoV–2 or with coronavirus disease 2019 (COVID– 19) by a test approved by the Centers for Disease Control and Prevention,

(II) whose spouse or dependent (as defined in §152 of the Internal Revenue Code of 1986) is diagnosed with such virus or disease by such a test, or

(III) who experiences adverse financial consequences as a result of being quarantined, being furloughed or laid off or having work hours reduced due to such virus or disease, being unable to work due to lack of childcare due to such virus or disease, closing or reducing hours of a business owned or operated by the individual due to such virus or disease, or other factors as determined by the Secretary.

Definition (III) should be the one which impacts many, if not all, of your clients.

In addition to these rules, the Consolidated Appropriations Act of 2020 (CAA) (PL 116-93) continued the penalty free withdrawal provisions and ability to spread out the reporting of the income over three years (and also to potentially reinvest the withdrawal within three years) for 2021, but only for disasters which were non-COVID and withdrawals were made no later than June 30, 2021.  Additional rules apply and may be reviewed here.

If you determine your client may benefit from one or more of the provisions outlined, there are several factors you may wish to consider in wrapping up their 2020 filing:

1. If you conclude reporting the income over three years makes sense, it must be reported in equal amounts in each of the three years.
2. Any withholding the taxpayer had will all be credited in the year the money was withdrawn, that being 2020.
3. While ratably reporting the income over 2020, 2021 and 2022, tax rates may increase, and the higher rates will be applied to the income reported in that year.
4. If the taxpayer decides to report the income all in 2020 and later reinvests part or all the early distribution before the three years have expired, it will be necessary to amend the 2020 return to reduce the reported income.
5. Ratably reporting the income over three years, while reducing AGI in 2020 will increase AGI in 2021 and 2022 which may have other unintended consequences depending on the taxpayer’s overall income during those future years.

Form 8915-E is used to report qualified disaster distributions, the decision to report the income ratably or to report repayments during the three-year period.

One last planning tip.  You may have clients who tell you they made traditional IRA contributions during 2020 but were forced to withdraw those deposits during the year. Treating the deposits as though they never occurred, or as non-deductible contributions may also help to minimize the tax impact of same-year withdrawals.

I wish you luck during these waning days (finally) of the 2020 filing season. After you’ve had a chance to refresh a bit, don’t forget to register for our virtual Fall Tax School sessions or webinars so you can prepare yourself for the next round of fun starting up again in just three short months.

By Tom O’Saben, EA