You may be surprised to learn that your tax advisor might want you to possess proof of a positive coronavirus test.
It might be a ticket to a penalty-free distribution from a retirement account.
The new CARES legislation allows penalty-free withdrawals from retirement accounts. The distribution must be included in taxable income, but the income may be spread evenly over three tax years. Taxes may be avoided entirely if the distribution is repaid within three years.
There is a logic to this.
Many people have been financially damaged, or worse, by the coronavirus pandemic. Tapping a retirement account may be the only available option for some people to keep financially afloat.
If things turn around it may be possible for the individual to repay a retirement plan distribution. Since contributions to retirement plans are limited, a three-year grace period to return the funds may be the only way to restore these funds to their intended purpose and avoid a tax effect.
If you don’t return funds, you can pay tax on one-third of the distribution each year. This phased income inclusion also means you can avoid reporting any income if you simply repay one-third of the loan each year for three years.
These special retirement plan tax breaks are available for loans and distributions that are “coronavirus-related.”
There are three ways to show that a distribution is coronavirus-related.
First, the beneficiary of the retirement account can be diagnosed with SARS-CoV-2 or with COVID-19 using a test approved by the CDC. Second, a spouse or dependent of that person can be diagnosed in the same manner.
A diagnosis for the individual, spouse or dependent makes the distribution coronavirus-related. End of story. No other proof needed. The distribution must occur in calendar 2020.
Tests have been hard to come by. Some people are said to be asymptomatic. Some are certain they had it from contact tracing (ick, you even know what that means now) with some period of symptoms. But no CDC-approved test? Could be a tax issue.
But wait, you protest, didn’t you say there are three ways? I did. This third way is for those who want the money but can’t use a positive test result to get into the club. But its meaning can be subjective.
To be precise, I will use the language of the tax law. An individual qualifies for the third way if he or she “experiences adverse financial consequences as a result of being quarantined, being furloughed or laid off or having work hours reduced due to such virus or disease, being unable to work due to lack of child care due to such virus or disease, closing or reducing hours of a business owned or operated by the individual due to such virus or disease, or other factors as determined by the Secretary of the Treasury.”
Is that you? Good. If you certify this to a plan administrator they can rely on your word. If it is your IRA you could just take the money – no need to explain why. At least for now.
At least for now? The individual will have the best information of whether they were adversely affected by the coronavirus in one of the ways described in the statute. This language is similar to a certification made by companies obtaining payroll protection loans (PPLs).
Some negative publicity arose after large firms obtained PPLs. Treasury issued a terse warning that the certification of adverse economic consequences required for PPLs should be carefully evaluated. This was a bit concerning to some recipients of these loans.
If you really need the money, and cannot pay it back, then any issue is with the IRS. You will pay tax on the distribution but file an IRS Form 5329 reporting a code to avoid the 10% early withdrawal penalty (if that would otherwise apply).
It may get trickier if you want to return the money within three years. The administrator has to be willing to take the funds back as a rollover. Hopefully they will. There is no guarantee that they will.
More interpretive guidance will be pouring out. Even so, plan administrators can still be naughty or nice about accepting returns.
James R. Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at email@example.com.