By Ian Berger
Do you have customers who took coronavirus-related distributions (CRDs) in 2020? In this case, they are faced with an immediate decision on how to include the CRD in taxable income. You also need to decide whether to repay the CRD and, if so, when the repayment is optimal.
The CARES Act – the COVID-19 relief package that went into effect on March 27, 2020 – allowed certain individuals affected by COVID to receive distributions from IRAs and business plans of up to $ 100,000.
These CRDs are typically taxable but receive three special tax breaks.
- First, they are exempt from the 10% pre-distribution penalty that normally applies to distributions to people under the age of 59½.
- Second, the taxable income from CRDs can be spread evenly over three years.
- Finally, CRDs can be repaid tax-free to an IRA or business plan over a three-year period.
On June 19, 2020, the IRS issued Notice 2020-50 which provided guidance on income inclusion and repayment options. It is important for consultants to understand the options available so that clients can take full advantage of these valuable tax breaks.
According to the IRS, evenly distributing CRD revenue across 2020, 2021, and 2022 tax returns is the default if the customer takes no action. The only alternative available is to include the entire CRD as 2020 taxable income. If this option is chosen, a choice must be made with the 2020 federal income tax return by filing Form 8915-E. For most taxpayers, the tax return has been postponed to May 17, 2021 or October 15, 2021, if renewed beforehand. (For Texas and Oklahoma residents, the no-extension deadline is June 15, due to the February storms.) Once conducted, the 2020 income elections are no longer subject to change.
While distributing taxable income over three years seems a breeze, some may find it worthwhile to include the entire CRD on their 2020 tax return. This would include those who suffered a financial blow in 2020 but expect their normal income levels to return in 2021 and 2022. The option to include 2020 would also benefit those who believe they will see an increase in income tax rates this year or next and want to subject as much income as possible to historically low 2020 rates.
By October of this year, it should be easier for clients to predict their relative income levels for 2020, 2021, and 2022 and to predict possible changes in tax law. For this reason, advisors may want to suggest that clients who have completed a CRD apply for an extension to allow more time to decide on their 2020 income intake choice. (Obviously, an extension makes less sense for those eligible for a required tax refund.)
The decision to repay a CRD is less urgent. The repayment is possible for a period of three years from the day after receipt of the CRD and is not affected by extensions of the tax return. Repayments must also be reported on IRS Form 8915-E, which is filed with the federal tax return for the year of repayment.
For those considering a CRD repayment, the benefit is that they can replenish their IRA or business plan accounts to allow those funds to grow again in deferred or tax-free manner. However, some customers may decide that the money can be better used, e.g. B. the restoration of a fund for “rainy days”. From a tax perspective, reducing income through repayment in 2020 may be less valuable if income was already lower due to COVID-19. On the other hand, repayment may be advisable if part of the taxable income falls into a lower tax bracket.
Different repayment rules apply depending on whether the CRD income is spread over 2020, 2021 and 2022 or whether the entire amount is included in the tax return for 2020.
If the 2020 inclusion option is chosen, the repayment will always reduce the 2020 CRD income – regardless of when it occurs within the three-year period. If a full CRD repayment is made prior to filing the 2020 tax return, the CRD will simply be omitted from the income reported on that filing. No amended return is required, but Form 8915-E must be submitted with the 2020 return (to report the 2020 income inclusion option). If the repayment is made after filing the 2020 return, the CRD must be reported about that return. Taxes paid on the CRD can be recovered by filing an amended declaration for 2020.
If an individual uses the three-year income distribution and repays 1/3 or less of the CRD, the year in which the repayment is recorded depends on the time between the date of tax return and the date of repayment. A repayment before filing a specific year’s tax return on time will offset the CRD revenue that would have been included on that year’s tax return. However, repayment after filing a given year’s return on time offsets the CRD income that would have been factored into the next year’s return.
What if the customer spreads the CRD income over 2020, 2021 and 2022 and pays back more than 1/3 of the CRD? In this case, the first third of the repayment is subject to the time rules mentioned above. For the additional portion of the repayment, the person can either carry over the excess amount to the next year or the excess to a previous year (or years). If the redemption option is chosen, an amended declaration must be submitted for each year of repatriation in order to recoup the taxes already paid on the CRD.
While the repayment rules are complicated, they allow the advisors to work with clients to plan CRD repayments in a way that maximizes their tax savings. As with the decision to include income, evaluating the repayment should take into account the client’s actual and projected income levels for 2020, 2021 and 2022, as well as the impact of potential income tax increases.
About the author: Ian Berger, JD, is an IRA analyst at Ed Slott and Company, LLC with over 30 years experience in retirement planning and IRA issues working in both the private and public sectors. Learn more about Ed Slott and Company’s 2-day virtual IRA workshop, Instant IRA Success. See also Slott’s Updated and No. 1 New Release, The New Retirement Savings Time Bomb. Click here to receive Ed Slott and Co.’s monthly IRA updates eNewsletter, which contains important breaking news and trending topics from the IRA world.