By Ian Berger
Do you have clients who took coronavirus-related distributions, or CRDs, in 2020? If so, they face an immediate decision about how to include the CRD in taxable income. They also must decide whether to repay the CRD and, if so, the optimal time to make repayment.
The CARES Act – the COVID-19 relief package enacted into law on March 27, 2020 – allowed certain individuals affected by COVID the opportunity to receive up to $100,000 of distributions from IRAs and company plans.
These CRDs are generally taxable but receive three special tax breaks.
- First, they are exempt from the 10% early distribution penalty that normally applies to distributions to those under age 59½.
- Second, taxable income on CRDs can be spread evenly over three years.
- Finally, CRDs can be repaid tax-free to an IRA or a company 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 advisers to understand the choices available so that clients can fully leverage these valuable tax breaks.
The IRS says that spreading CRD income evenly over 2020, 2021 and 2022 tax returns is the default if the client takes no action. The only available alternative is to include the entire CRD as 2020 taxable income. If this option is chosen, an election must be made with the 2020 federal income tax return by filing Form 8915-E. For most taxpayers, the tax return deadline has been pushed back to May 17, 2021, or Oct. 15, 2021 if they go on extension before then. (For Texas and Oklahoma residents, the deadline without going on extension is June 15 due to the February storms.) Once made, the 2020 income election cannot be changed.
Although spreading taxable income over three years may seem like a no-brainer, electing to include the entire CRD on the 2020 tax return may be worthwhile for some. This would include those who took a financial hit in 2020 but expect their normal income levels to return in 2021 and 2022. The 2020 inclusion option 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 2020, 2021 and 2022 income levels and to forecast potential tax law changes. For this reason, advisers may want to suggest that clients who took a CRD go on extension to buy more time to decide whether to elect the 2020 income inclusion. (Of course, going on extension makes less sense for individuals entitled to a needed tax refund.)
The decision about repaying a CRD is less pressing. Repayment is available for a three-year period beginning on the day after the CRD was received and is unaffected by any tax return extensions. Repayments also must be reported on IRS Form 8915-E, which is filed with the federal tax return for the year the repayment is made.
For those considering CRD repayment, the advantage of doing so is the ability to replenish their IRA or company plan accounts so those funds can again enjoy tax-deferred or tax-free growth. But some clients may decide there are better uses for the money, such as restoring a “rainy day” fund. From a tax perspective, reducing 2020 income through repayment may be less valuable if income was already lower because of COVID-19. On the other hand, repayment may be advisable if it drops a portion of taxable income into a lower tax bracket.
Different repayment rules apply depending on whether CRD income is spread over 2020, 2021 and 2022 or an election is made to include the entire amount on the 2020 tax return.
If the 2020 inclusion option is elected, repayment will always reduce 2020 CRD income – no matter when it is made within the three-year period. If a full CRD repayment is made before the 2020 tax return is filed, then the CRD is simply omitted from income reported on that filing. No amended return is necessary, but Form 8915-E must be filed with the 2020 return (to report the 2020 income inclusion election). If repayment is made after the 2020 return is filed, the CRD must be reported on that return. Taxes paid on the CRD can be recouped by filing an amended 2020 return.
If an individual uses the three-year income spread and repays 1/3 or less of the CRD, the year the repayment is recognized depends on the timing between the date of the tax filing and the date of repayment. A repayment made before the timely filing of a particular year’s tax return offsets the CRD income that would have been included in that year’s return. However, a repayment made after the timely filing of a particular year’s return offsets CRD income that would have counted in the next year’s return.
What if the client is spreading CRD income over 2020, 2021 and 2022 and repays more than 1/3 of the CRD? In that case, the first one-third repaid is subject to the above timing rules. For the additional portion of the repayment, the individual can either carry forward the excess amount to the next year or carry back the excess to a prior year (or years). If the carryback option is chosen, an amended return must be filed for each carryback year to recoup taxes already paid on the CRD.
While complicated, the repayment rules will allow advisors to work with clients to time CRD repayments in a way that maximizes their tax savings. Like the income inclusion decision, the repayment evaluation should consider the client’s actual and projected income levels for 2020, 2021 and 2022, as well as the effects of any potential income tax increases.
About the author: Ian Berger, J.D., is an IRA Analyst with Ed Slott and Company, LLC with over 30 years of experience with retirement plan and IRA issues working in both the private and public sectors. Get more information on Ed Slott and Company’s Virtual 2-Day IRA Workshop, Instant IRA Success. Plus, See 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, featuring important breaking news and trending topics in the IRA world.