Tax Law Changes Related to Early Distributions from Retirement Plans

Recent tax law changes provide options related to the tax and the 10% penalty assessed for an early withdrawal from a retirement account. The Coronavirus Aid, Relief, and Economic Security (CARES) Act provides for expanded distribution options and favorable tax treatment for up to $100,000 of early coronavirus-related distributions from eligible retirement plans for those individuals hit hard by the pandemic.

Generally, an early distribution from a retirement plan is subject to an additional 10% penalty if the individual is not aged 59½ or older. The penalty is in addition to income tax due on traditional retirement distributions. Under §2202 of the CARES Act, the new law:

  • Excludes these early distributions due to specific COVID-19 reasons from the 10% penalty;
  • Permits taxpayers to include the early distribution in income ratably over three years (taxpayers can also elect to include the entire amount in the year of the distribution); and
  • Exempts from income tax any distributions that are paid back to the individual’s retirement account within three years.

To benefit from these rules, taxpayers must meet certain requirements:

  • The individual, the individual’s spouse, or the individual’s dependent is diagnosed with COVID-19; or
  • The individual experiences adverse financial consequences as a result of the coronavirus.

Although individuals will not incur an additional 10% penalty on these early distributions, if they meet the requirements above, these distributions are still subject to income tax in the year of the distribution if taken from a traditional (tax-deferred) retirement account. This is the case even if the taxpayer intends to repay the early distributions within the permitted three-year period. If the taxpayer does repay the early distributions within the three-year period, the taxpayer must amend his/her tax return(s) in order to receive a refund of the additional taxes paid over the three-year period. Taxpayers might be surprised to learn that, not only do they need to pay income tax on these distributions, but they will also need to face the administrative challenge of filing amended return(s) at a later date to get their money back.

The Internal Revenue Service is still working on providing additional guidance related to these early distributions but advises taxpayers to refer to IRS Notice 2005-92 that applied to similar distributions taken by individuals affected by Hurricane Katrina. The rules laid out in Notice 2005-92 provide that a taxpayer who pays an early distribution back by his/her tax return’s original or extended tax return due date does not need to include the qualifying distribution in income for the applicable tax year. Additional information regarding Coronavirus-related relief for retirement plans can be found on the IRS website.

The key here is that a taxpayer can pay his/her early distribution(s) back by his/her extended tax return’s due date. This might be a favorable option to taxpayers who took an early distribution due to financial hardships and uncertainty early on in the pandemic but has since found themselves in a more stable financial position. By extending his or her 2020 tax return, the taxpayer is also extending the 2020 early retirement distribution repayment deadline to October 15, 2021. This option provides taxpayers additional time to arrange for the repayment, avoid income tax on the early distribution, and avoid the aggravation of filing amended returns in the future. As we all know, avoiding any administrative hassle with the IRS is always the route to choose if possible.

As always, feel free to contact your GYF Tax Executive at 412-338-9300 for assistance.

Dan Oberst

Dan Oberst

Dan has nearly 10 years of tax experience. He specializes in providing tax compliance and research services to individual and business clients, primarily in the manufacturing and service industries. Dan also engages in special project work, providing fixed asset analysis and handling various state tax issues.

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