Strategic Use of Penalty-Free Coronavirus-Related Distributions from Retirement Accounts
This is your last chance to liberate retirement money penalty-free from pre-tax accounts!
If you are less than 59 and a half, you can use a Coronavirus-Related Distributions (CRD) strategically to your tax advantage. The CARES Act provided the tax savvy a gift: access your retirement accounts without penalty. This gift ends in at the end of 2020.
With a CRD, you can take up to 100k from an IRA or 401k penalty-free. What can you do with this money formerly locked away in your retirement accounts? And what are the implications?
Let’s understand Coronavirus-Related Distributions and consider tax strategies for those who may want to use them before the end of the year. Last chance for CRDs!
Caveats and Cautions Using Coronavirus-Related Distributions
First off, it is important to understand you are giving up tax-sheltered growth when you take a Coronavirus-Related Distribution. Only take money out of your tax-protected space if you have a better use for it.
Many folks in early retirement are already living off their tax-sheltered accounts (though SEPP-72(t) or Roth Conversion Ladders, etc). CRDs for those in early retirement may improve on the the drawdown plan. We will look at other potential uses for those who are still employed below.
Next, of course, you will pay taxes on CRDs. Coronavirus-Related Distributions are penalty-free distributions up to 100k per person, but you will pay ordinary income taxes. So, you MUST DO TAX PLANNING prior to considering Coronavirus-Related Distributions. Of course, you can return the money to a pre-tax account before 3 years expires and suffer no ordinary income taxes. This is where the strategy comes alive!
How much can you take? If you are married and both you and your spouse have IRAs or 401ks, you can take out $200,000 this year penalty free. That’s a lot of liberated penalty-free retirement money to repurpose!
Let’s look at some tax rules before we get too far gone rolling in the penalty-free dough.
Tax Implications of Coronavirus-Related Distributions
You will always pay ordinary taxes on distributions or withdrawals from pre-tax accounts. But how much tax you pay depends on your other sources of ordinary income.
For example, if you have no other sources of ordinary income, your first 12 or 24k (the standard deduction) of distributions are tax-free! After that, you pay taxes depending on where you fall in the progressive tax brackets.
With Coronavirus-Related Distributions, you can pay all taxes in 2020, or you can spread the taxes out over three years (2020, 2021, and 2022). You pay the taxes if you take an actual distribution of the money for use as an after-tax resource.
But, also remember, you can return the the money back to an IRA within 3 years and pay no taxes at all. Essentially, CRDs are a 3-year long 60-day roll overs!
A 3-Year Long 60-Day Roll Over
What is a 60-Day Roll Over? That is when you take money out of your IRA as a check (rather than trustee-to-trustee direct transfer or roll over) and then put the money back in an IRA prior to 60 days. In the case of a 60-day roll over, no harm no foul: no taxes are owed as it is not a distribution. You can do one of these 60-day roll overs every 365 days.
For CRDs, you can take money out of your 401k and put it back in an IRA or any other qualified retirement plan and not owe the taxes. And, you have 3 full years from constructive receipt of the money.
What is constructive receipt? Say you ask for a check from your 401k in December of 2020 but don’t get the check in your hand (because you are in jail or on vacation, etc.) until February of 2021. You then have 3 years—until February of 2024—to put the money back in a pre-tax account. Of course, you will likely have to amend your 1040s for a couple years if you do this as you will pay the tax, but can get a tax credit back if you follow the constructive receipt rules.
Regardless, there is a lot of flexibility if and when you pay taxes on your CRDs.
Let’s get to strategy. When might you consider taking a Coronavirus-Related Distribution for strategic purposes?
Strategies for Coronavirus-Related Distributions
Remember, prior to the age of 59 and a half, there is a 10% penalty for withdrawing money from a qualified retirement plan or an IRA. 401k plans may allow penalty-free access at age 55 (the rule of 55), and first responders can often access 403b plans at 50. 457 plans are great for early access but watch out for non-governmental 457b plan distribution options.
Also in the early retirement playbook, you can find 72(t) SEPP distributions (which are not affected by CRDs, BTW), and the 5-year Roth Conversion Ladder.
These are great ways to access retirement accounts in early retirement without the 10% early withdrawal penalty.
Coronavirus-Related Distributions now offer, at least for a short time, some additional strategies for accessing retirement money without penalty. Considerations include:
Other Sources of Ordinary Income
What is your taxable income going to be in 2020, 2021 and 2022 when you must pay taxes on CRDs?
Accounts Available to take CRDs
If you and your spouse have IRAs and 401k/403b plans, you can take up to $200k
Don’t Forget Tax Drag
Don’t trade tax-deferred growth for taxable growth. This is tax drag and it will cost you as you will at least owe capital gains taxes on growth in a brokerage account.
Please Don’t do this if you are in Accumulation
“Common folks” should not try this trick at home. In fact, you will see “experts warn against taking money out of your retirement accounts early” when reading about CRDs. Duh!
Well, Financial Independence Retire Early folks take money out of retirement accounts early in a tax-efficient manner all the time part of their drawdown plan.
You just got another tool in your toolbox!
Conversely, don’t take money out of your retirement accounts during accumulation. If you are still growing your assets, you need the tax-protected growth for the future.
You Get a Mulligan
If you don’t want the money, you can always put it back in any pre-tax account before three years expire!
These Are Not Considered Hardship Distributions
There are a whole set of hardship distributions which don’t apply to CRDs
You Can Repay into your 401k to Continue with Backdoor Roth IRA
Usually once you take a distribution from a 401k or 403b, the money is out and cannot be put back in. Repayment of CRDs back into the 401k, however, are considered direct roll overs so you can put the money back into a 401k rather than an IRA. This will allow you to continue to do backdoor Roth IRAs without worrying about the pro-rata rule.
A CRD is an eligible rollover distribution and can be rollover over (a “repayment”) into any account able to accept rollovers.
No Tax Withholding
Normally, 20% is withheld from 401k distributions for taxes. People sometimes mistake that this is the actual amount of taxes owed on the distribution. It isn’t, it just holds some money back for the feds. The actual amount you owe depends on your tax return and your marginal tax rate. There is NO TAX Withholding on CRDs.
Interested in Real Estate?
Here is a hack. Take out money from your 401k and then put it in a QRP or self-directed IRA to invest in real estate. Hello, real estate folks? This is a dream scenario where you can access money “locked away” in the stock market at your work 401k and use it to buy real estate.
Seems like a dream come true. And you can even keep the real estate investment tax-deferred. No early withdrawal penalties and you get to escape wall street and invest in real estate!
Withdrawal vs. 401k Loan
If you take a 401k loan, you will be expected to pay the money back over 5 years. If you leave the job before 5 years, the money will be due back in the account by the October the year after you separate from service or you will owe taxes AND the 10% penalty. Loans do not get you off the hook for the 10% penalty! IF you separate from service while you owe the loan, it is considered a withdrawal from your qualified retirement account and not a CRD.
Loans have been increased from 50k to 100k with the CARES act. You can borrow up to 100% of your account balance. Ouch. Be careful. They are another option, but have severe limitations and are not indicated in early retirement.
Using CRDs as a Creative Way to do Partial Roth Conversions
But beware the step doctrine. If you take 90k out in 2020 and do 90k of Roth conversions all in 2020, likely you should plan on paying taxes on the 90k conversion in 2020. You can’t just take 90k out as a distribution and put it into a Roth, as this will be considered excess contribution into your Roth and is subject to a 6% per year penalty on the excess.
Instead, take 90k out in 2020 and do 30k of conversion in 2020, and in 2021 and 2022 as well. In this situation, pay taxes on the conversion in the year you convert.
Coronavirus-Related Distributions are like a 60 day roll over, except you have 3 years to do the rollover. So, if you remember to code the Roth “contribution” as a rollover, you should be able to avoid excess contributions. This is an advanced idea and not ready for prime time until we get some more IRS guidance.
Final Thoughts on CRDs: Eligible Individual
Don’t forget, you must be eligible to use a CRD. To be an eligible individual, you or a spouse must have been diagnosed with or had adverse financial consequences due to Covid-19. That is just about everyone I know!
Also, you only need to self-certify that you were harmed by the Covid-19 public health emergency. Yes, that is just about everyone I know. I don’t think the IRS will have you jumping through hoops to get access to this money. That said, document how you were harmed.
Summary: Last Chance for Coronavirus-Related Distributions
What “normal” people are being told: Avoid Coronavirus-Related Distributions unless you need to pay off high interest debt, pay for basic needs, or avoid losing your home.
There are some strategies for those who are advanced, however! We plan to access our pre-tax money in a way that suit us. A good drawdown plan is already tax-efficient and avoids the 10% early withdrawal penalty. You now have a new strategy to access your retirement accounts!
The basic idea: liberate early retirement spending money from pre-tax accounts in a tax-efficient, penalty-free way.
Don’t forget, taxes are on sale right now. If you will need spending money in the future, get it before 2026 when taxes increase again. When TCJA expires, expect compressed tax brackets, reduced standard deductions, and pre-TCJA tax brackets. A little extra tax drag may well be worth owing less in ordinary taxes in the future.
Coronavirus-Related Distributions are important strategic tools that deserve consideration.