Under normal circumstances, withdrawals from retirement plans and IRAs taken by an individual prior to age 59½ are subject to an additional 10 percent tax or penalty. With the passage of the CARES Act in March, that penalty has been waived for withdrawals taken between January 1, 2020 and December 31, 2020.
Individuals younger than 59½ and who meet the IRS criteria, are able to take COVID-19-related distributions of up to $100,000 in 2020 sans the 10 percent penalty. Since funds in retirement plans and IRAs are generally contributed to on a tax-deferred basis, participants are still required to pay taxes on the full amount when the funds are distributed.
Generally, it is not advisable to prematurely dip into retirement accounts, as doing so could jeopardize that person’s financial future in retirement. For individuals impacted by COVID-19, whether it be a job loss, furlough or reduction in income, taking an early withdrawal from a retirement plan or IRA might be the only viable option, but this should be an option of last resort.
Under the CARES Act, the IRS has also waived the mandatory 20 percent federal tax withholding on early withdrawals from a plan like a 401(k) or an IRA for 2020. Individuals who take a distribution from a plan will still owe taxes on that money, but they can report that income and spread out the payments over the next three years. For example, if an individual withdrew $30,000 in 2020, that person could report income of $10,000 per year on their federal return for years 2020, 2021 and 2022.
Keep in mind, it might make sense from a tax perspective to pay the full taxes on the distribution in the year in which the individual has a lower taxable income if they can afford it. If the individual lost his or her job, was furloughed or had their work hours or income reduced in 2020, it might be advantageous from a tax perspective to pay the taxes for that tax year due to the lower income. It is always a good idea to speak with a tax advisor and financial planner about the potential tax consequences that could arise when taking a distribution from a retirement plan or IRA.
For individuals who find themselves in a crunch in 2020 due to COVID-19 but ultimately are able to pay the money back to their retirement plan, the IRS is allowing individuals who withdraw funds to return those distributions and get a refund on the taxes paid. Funds returned to the plan are not subject to annual contribution limits. This must be done within three years after the date the distribution was received, and doing so may require the individual to file amended tax returns.
Utilizing a 401(k) loan is another option for individuals who find themselves in a tight financial situation, but this alternative is not without drawbacks. Individuals are not required to pay taxes on a 401(k) loan if the money is paid back.
Generally, individuals will have five years to repay a 401(k) loan, but that can vary depending on the 401(k) plan. Since the person is essentially borrowing money from themselves, they are paying the principle and interest to themselves. Understand, a 401(k) does need to be paid back. If the individual is ultimately not able to pay the loan back for any reason, the remaining balance owed on the loan will be treated as a taxable distribution and will be subject to the 10 percent penalty if the individual is under the age of 59½.
Due to the CARES Act, any 401(k) loan payments due between March 27, 2020 and December 31, 2020, can be postponed. The dollar limit on loans made in that timeframe has been raised from $50,000 to $100,000. As mentioned above, it is always prudent to seek the guidance of a tax advisor and financial planner prior to making decisions regarding retirement plan distributions and the potential tax consequences that may arise.
Authored by Dennis Culver, Insight Wealth Strategies
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Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.