You may have heard that Congress passed a series of laws at the end of 2019/beginning of 2020 that affect your IRA, including reducing the taxes that apply to IRA withdrawals. While this is true, these law changes are complex and have been clarified and expanded by subsequent IRS guidance. Many IRA owners are not clear on what relief is available or to whom it applies. Here, we have compiled a summary of the various laws (and guidance issued by the IRS) to keep you up to date on the changes that impact IRA withdrawals and taxation.
If you have been affected by COVID-19
If you meet the eligibility requirement to take a “coronavirus-related distribution” (CRD), you may take up to $100,000 out of your IRAs in 2020 and take advantage of the following relief.
- The 10% early distribution tax (applicable to IRA owners under age 59 ½) is waived.
- You may choose to claim the entire amount distributed (up to $100,000) in your taxable income for 2020 or spread the distribution amount in three equal portions over your 2020, 2021, and 2022 tax years.
- You may re-contribute any portion of the 2020 withdrawal to your IRA within three years of the date of distribution. You may recoup any income tax paid on the amount you repay to your IRA and/or avoid paying tax on distributed amounts you haven’t yet included in income.
You are eligible to take a CRD if
- You, your spouse, or a dependent tested positive for COVID-19; or
- You have experienced adverse financial consequences because you, your spouse, or a member of your household, due to COVID-19,
- Was quarantined, furloughed, laid off, subject to reduced work hours
- Was unable to work due to lack of childcare,
- Had their business close or work hours reduced,
- Had a reduction in pay or self-employment income, or
- Had a job offer rescinded or start date delayed.
If you are a beneficiary and withdraw money from an inherited IRA in 2020, you may treat the distribution as a CRD (i.e., choose to spread out the taxation over three years), but you cannot repay the CRD into the inherited IRA (unless you are a spouse beneficiary).
Distribution and tax-related changes NOT related to COVID-19
Other changes to the IRA distribution taxation rules come from the SECURE Act, which was passed in December 2019, in part, to help individuals save more for retirement. Some of the changes also provide relief if you need to tap into your IRA to help cover certain expenses before you reach age 59½. The tax laws apply a 10% early distribution tax to taxable distributions taken prior to the IRA owner reaching age 59½. This “penalty” tax applies in addition to regular income tax. It is meant to deter retirement savers from tapping into their savings before retirement, but it is not meant to punish those who may need to use some of their retirement savings for emergencies along the way. The tax laws provide several exceptions to the 10% early distribution tax (see table below). The following two exceptions were changed or added by the SECURE Act:
- Medical Expenses – For years prior to 2021, the 10% early distribution tax will not apply to distributions taken to help pay for medical expenses that exceed 7.5% of your adjusted gross income (AGI) for the year. A previous law change increased this threshold to 10%, but the SECURE Act ensures the 10% threshold will not apply until tax year 2021.
- Childbirth and Adoption Expenses – Beginning in 2020, you may withdraw up to $5,000 from your IRA, free from the 10% early distribution tax, to help pay for childbirth or adoption expenses. A qualified childbirth or adoption withdrawal of up to $5,000 can be taken by each parent per child (for a total of $10,000 per child). An eligible adoptee is anyone other than a spouse’s child, and the child must be younger than age 18 or have special needs. Distributions must be taken within one year of the birth or adoption. These distributions must be included in your taxable income for the year (to the extent the IRA distribution would otherwise be taxable), but you may choose to repay these distributions to your IRA at any time.
Exceptions to the 10% Early Distribution Tax for IRA Withdrawals
- Attainment of age 59½
- Substantially equal periodic payments
- Health insurance premiums for unemployed persons
- Unreimbursed medical expenses more than 7.5% of AGI
- First-time homebuyer expenses (up to $10,000)
- Qualified higher education expenses
- IRS tax levy
- Qualified reservist distribution (may repay to IRA)
- Birth or adoption expenses up to $5,000 (may repay to IRA)
- Coronavirus-related distribution (CRD) up to $100,000 for 2020 (may repay to IRA)