Q: I’m 49 and was laid off due to COVID cutbacks. A former co-worker says I can tap my IRA tax-free this year. How do I do that?
A.: Tim, there is no provision for tax-free IRA distributions. What your ex-coworker may be referring to is a Covid-related Distribution. The CARES Act, aka the stimulus package, passed earlier in the year waives the 10% penalty normally incurred for IRA withdrawals prior to 59½ if you were adversely affected by COVID. Only the 10% penalty is waived not the income taxes. Distributions can be made at any time in 2020 up to a cumulative total of $100,000. (Similar rules apply to tapping a 401(k) or other qualified retirement plan but plans are not required to allow COVID-related transactions.)
To be considered COVID-related, you, your spouse, or dependent must be 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; or you must experience adverse financial consequences.
Adverse consequences are being furloughed or laid off, having work hours reduced, being unable to work due to lack of child care, or closing or reducing hours of a business that you own or operate; due to SARS-CoV-2 or COVID-19
When you take the distribution you can either report all the income on your 2020 tax return or split the income evenly over 2020, 2021, and 2022. You cannot split in any other proportion. It is important to note that you are splitting the income and not the taxes due. If you take $45,000 of distributions, you are either putting $45,000 of distributions on your 2020 tax return or $15,000 on the 2020, 2021, and 2022 returns respectively.
It is possible that if you go back to work, your income could be higher in 2021 or 2022, creating a higher tax rate than if you paid it all up front. There is a bit of a safety valve in such a scenario.
You can repay any portion of a distribution at any time up to three years from the day after you take a distribution. Normally, there is a once-per-year 60-day rollover rule for IRA distributions that limits your ability to return money to an IRA and eliminate tax on the distribution. This once a year rule does not apply to COVID-related distributions.
So, if you paid for the $45,000 distribution on your 2020 return, you could get your taxes refunded by putting the $45,000 back in the IRA after you returned to work. You would file an amended 2020 return reducing your reported distributions for 2020 by any portion of the $45,000 paid back within three years.
If you opt to spread the income over three years and pay a portion of what you took out at some later date, its more complicated. The payback causes the income to be reduced proportionately on all three years returns.
For example, say you take out $45,000 in 2020 and spread it over three years ($15k on each year’s tax return). Right before your three years are up, you payback $33,000. This makes the net distribution $12,000 ($45,000 – $33,000), or $4,000 a year. You would amend your 2020, 2021 and 2022 tax returns to show IRA distributions $4,000 each year. You would be refunded the taxes attributable to the $33,000 ($11,000 2020, 2021, and 2022 respectively.)
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.