Adapted from an article originally posted on Forbes.com
The 2020 tax season is upon us, and many people are wondering how the pandemic will impact their tax returns. One of the areas in question concerns the coronavirus-related distributions (CRDs). If you took these distributions, you now face the decision about how to include these CRDs in your tax filings for this year and beyond. In this post, I will seek to clarify the various options available for income inclusion and CRD repayment as per this IRS issued notice in hopes that you are better able to determine which approach provides you with the most financial benefit.
What is a Coronavirus Related Distribution?
The CARES Act, which was passed during late March 2020, allowed for penalty-free distributions from retirement accounts if specific conditions applied that proved you or your household were adversely affected by the coronavirus. You can read more about that here. If you qualified for this distribution and decided to take it, you were then given various options on how to pay the taxes or return the money into a retirement account without paying taxes and penalties. The option that you elect can greatly impact the taxes you pay, so it’s important to know what those options are so that you pick the optimal approach.
What are my options?
Option 1: Including CRDs as Taxable Income
If you took a pre-tax CRD then it will be subject to federal income taxes. You can choose to include the entire amount of the CRD as 2020 taxable income. This election would have to be made by filing form 8915-E by the tax filing deadline (including extensions). Once you make this election, it cannot be changed. Otherwise, the default treatment is to include 1/3 of the CRD as income for the 2020, 2021, and 2022 tax years.
Why would I want to include my CRD in 2020 taxable income?
If your income was negatively impacted in 2020 and you expect your income to return to normal or higher levels in 2021, it might present an opportunity to absorb that payment and pay lower taxes in a low-income tax year. In addition, if you feel tax rates might go up in the near term, this could make the potential tax savings even more impactful.
Why wouldn’t I want to include my CRD in 2020 taxable income?
If you are unsure how your tax situation or potential income situation may change, you may opt to file an extension and take the wait and see approach. This can help you determine if it makes more sense to take the income in 2020, or defer part of it to a future tax year where you might receive more favorable tax treatment or decide to pay some or all of it back (more details on that below). Also, if you are expecting a refund and need it soon, you should weigh your immediate financial needs accordingly and may opt against extending the tax deadline.
Option 2: CRD Repayments
You can choose to repay all or part of the distribution within 3 years of taking the CRD and apply the payments over the next 3 tax filing years (2020, 2021, and 2022). You can generally repay these distributions into an IRA or a company plan that accepts rollovers. There are 2 repayment options with a few nuances in each.
The first repayment option involves making an election to include the CRD in 2020 income as a one-year inclusion. If this option is selected then no matter when repayment is made within the 3 year period, 2020 CRD income will be reduced. Now the timing of this repayment really matters. If the repayment is made before the 2020 tax filing deadline, then the CRD is not included in 2020 income, and there is no need to file an amended return. If the repayment is made after the 2020 tax filing deadline, the income will have to be included as part of your 2020 income, taxes would be paid on that, and the only way to get that money back would be to file an amended return.
In addition, considering the longer-term trade-offs versus the shorter-term trade-offs is important. For example, putting that money back into your retirement account ASAP will allow that money to continue to grow tax-deferred for retirement. You can use a calculator like this one to estimate the growth of your savings. On the flip side, if your income is questionable and you are experiencing considerable financial insecurity, those funds might be better used to shore up your emergency savings. The decision you make can cost you time, money, and stress, which means that extra consideration should be taken to ensure you make the best decision for your specific situation.
The second repayment option involves when CRD income is spread equally in thirds over the next 3 tax filing periods: 2020, 2021, and 2022. Again, the way you file and decide to repay the CRD really matters for your tax planning and filing. Let’s break that down.
Repayment made before filing tax return: If a repayment is made before the tax filing deadline, that repayment will be applied to offset the CRD income that would have been included that tax year. If the repayment is made after the tax filing deadline then the payment would need to be applied to offset the next tax year’s CRD income.
Carry forward or carry back repayment: If you make a larger than 1/3 repayment before the tax filing deadline, the first 1/3 portion is applied to offset CRD income that is included for that tax year. The excess can then be carried forward to offset the CRD amount the next tax year (if applicable) or it can be carried back to a prior year or years by filing an amended return. It’s important to reiterate that the time period you are working in is the 2020, 2021, and 2022 tax periods so you can only play within those years when thinking about carrying forward or carrying back. You can see examples of how all these repayment options play out in the IRS notice (pages 13-16).
Deciding whether and how to take advantage of CRD income inclusion and repayment options has important financial consequences that require careful planning. A great place to start with any questions would be to consult an unbiased financial planner. Your employer might just provide you with one through a financial wellness benefit. Otherwise, many individuals might be better served by working with a qualified tax professional so that their CRD strategy is done in a way that maximizes your tax benefit and allows you to keep more money in your pocket.