Did you take a coronavirus distribution (CVD) of up to a combined limit of $100,000 from one or more of your traditional IRAs in 2020?
You can recontribute the CVD amount(s) back into one or more traditional IRAs within three years of the withdrawal date(s). You treat each withdrawal and later recontribution within the three-year window as a federal-income-tax-free IRA rollover transaction. That’s the tax advantage.
The non-tax advantage is that there are no restrictions on how you can use CVD funds. You can use the money to pay bills and recontribute later—within the three-year window—when your financial situation permits. You can help out your adult kids now and recontribute later. Whatever.
Key point. The favorable tax treatment applies equally to CVDs taken from garden-variety traditional IRAs, SEP-IRAs, SIMPLE-IRAs, and employer retirement plans that allowed CVDs.
Downside: Inconvenient Interim Tax Consequences
Unfortunately, you must put up with some potentially awkward interim tax consequences before you arrive at the tax-free-rollover-equivalent outcome. The interim tax consequences can diminish the cash-management advantages of the CVD deal, and they require filing amended returns to gain federal-income-tax-free treatment.
If you take several CVDs (up to the $100,000 combined limit), the interim tax consequences apply separately to each CVD. But let’s keep things as simple as possible to make the following examples easier to understand.
Example 1. Recontribute in 2023.
You were eligible for the CVD privilege. You took one $100,000 CVD from your traditional IRA in 2020. The $100,000 would be fully taxable under the regular federal income tax rules for traditional IRA withdrawals. (If you’ve made non-deductible traditional IRA contributions over the years, the withdrawal would not be 100 percent taxable, but we are keeping
things simple here.)
The usual way to line up federal-income-tax-free treatment for your CVD involves spreading the $100,000 of taxable income that you would report under the regular tax rules equally over 2020, 2021, and 2022. So, you would report $33,333.33 on your 2020 Form 1040. Ditto for 2021 and 2022. This treatment is called the “three-year ratable income inclusion method.”
After recontributing the entire $100,000 sometime in 2023, before the three-year window closes, you file amended returns for 2020, 2021, and 2022 and get back the interim federal income tax hits for those years. At the end of the day, the CVD is federal-income-tax-free, as advertised. But you had to jump through some hoops to get there
Example 2. Recontribute before 2023.
You have the necessary cash, so you choose not to wait until sometime in 2023 to recontribute the CVD amount. For instance, if you use the ratable income inclusion method and then recontribute the entire $100,000 in 2022, there won’t be any interim tax hit for that year. You would generally file amended returns for 2020 and 2021 to get back the interim tax hits for those years. Once again, the CVD is federal-income-tax-free at the end of the day. Once again, you had to jump through some hoops.
Example 3. Report all CVD income on your 2020 return.
You also have the option of electing to report the entire $100,000 of CVD income on your 2020 Form 1040, which you may or may not have filed yet. If you then recontribute all or part of the $100,000 within the three-year window, and you’ve already filed your 2020 Form 1040, you must file an amended 2020 return to get back all or part of the tax hit for that year
Tax Results If You Don’t Recontribute Within the Three-Year Window
You always have the option of simply keeping all or part of your CVD money. You’ll have taxable income from the CVD amount that you don’t recontribute.
Good news. Regardless of what you choose to do with your CVD, you won’t owe the dreaded 10 percent early withdrawal penalty tax that generally applies to traditional IRA withdrawals taken before age 59 1/2. CVDs are completely exempt from the penalty tax.
The same is true for the SIMPLE-IRA. IRS Notice 2020-50 clarifies that CVDs taken from a SIMPLE-IRA are exempt from the 25 percent early distribution penalty tax that generally applies to SIMPLE-IRA withdrawals taken before age 59 1/2.
More good news. When you recontribute a CVD amount within the three-year window, it’s deemed to be a direct trustee-to-trustee transfer that’s exempt from the one-IRA-rollover-per-year limitation.
Bad news. According to IRS Notice 2020-50, beneficiaries of inherited IRAs can receive CVDs as long as
- they are eligible individuals,
- they can follow the three-year ratable inclusion rule to report taxable income from CVDs, and
- their CVDs are exempt from the 10 percent early distribution penalty tax.
But only an IRA CVD that is otherwise eligible for tax-free rollover treatment can be recontributed. Therefore, CVDs received by beneficiaries of inherited IRAs (other than the surviving spouse of the IRA owner) cannot be recontributed. So, no tax-free-rollover-equivalent deal for those folks. Sorry.
Takeaways
In the right circumstances, taking advantage of the CVD privilege can be a good, tax-smart financial planning strategy. Some “experts” scoff at that statement, because they think taking money out of an IRA before retirement is always a terrible idea. But we stand by the statement.
That said, if you don’t recontribute CVD amounts by the due date for your 2020 Form 1040, there can be inconvenient interim tax consequences. Or not. It depends on your specific circumstances.
For any CVD amount that was not recontributed in 2020, you have until October 15, 2021, to make the decisions that will determine how that amount will be taxed, as long as you extended the deadline for filing your 2020 Form 1040 to October 15, 2021 (or you file a superseding return).
If you have questions about your CVDs, please don’t hesitate to call me on my direct line at 509-543-7600 or send a request HERE.
July 2021
This blog does not provide legal, financial, accounting, or tax advice. This blog provides practical information on the subject matter. The content on this blog is “as is” and carries no warranties. TaxMedics does not warrant or guarantee the accuracy, reliability, and completeness of the content on this blog. Please contact us directly to discuss how this information may be used based on your actual facts and circumstances.