Unfortunately this last year has caused many hardships and frustrations for many people. Some have had their hours at work severely reduced, or were laid off, or lost their job completely due to the global pandemic. While the government has sent out a couple stimulus packages, offered forgivable PPP loans, and expanded unemployment benefits, some have still needed to take out a distribution from their retirement account to help make ends meet for their business or for their personal lives.
Not the best idea
It is generally never a good idea to take an early distribution from a retirement account (an IRA, 401k, etc). For one thing, it's basically stealing from your future self, and seriously hinders the ability for your money to grow at a compound rate. Retirement accounts have contribution limits, making it hard to later make up for the withdrawal via future deposits. Also, the distribution adds to your ordinary income and will be taxed, and could even put you into the next higher tax bracket. In addition, usually if a distribution is taken from a retirement plan before the age of 59 1/2, not only is it taxed as ordinary income, but it also comes with an extra 10% tax penalty. OUCH!
As an example, lets say you are married filing joint in 2020, and as a couple you made $70,000 in taxable income ($94,800 before the Standard Deduction). During the tax year, lets say you also took out an early distribution from a 401k in the amount of $20,000. Now, your taxable income comes to $90,000.
The 2020 tax bracket for married filing joint is 12% for income ranging from $19,750 to $80,250, and 22% for any income between $80,250 to $171,050. So in a normal year, that $20,000 distribution would have a 10% penalty attached to it, along with being taxed at 12% for the first $10,250, and at 22% for the remaining $9,750 part of the distribution.
What does that equate to? With the penalty and tax, that created a $5,378 additional tax bill. Now the $20,000 distribution really became $14,622. To make matters worse, if you have a state income tax, then you're paying an additional 6% to 12%, depending on the state you live in. Super Ouch!
CARES Act of 2020
Included in the stimulus package referred to as the CARES Act, enacted on March, 27 2020, there was also a provision for distributions from retirement plans. A qualified individual affected by Covid-19, is allowed to take a distribution of up to $100,000 from an eligible retirement plan. This distribution could be taken at any time during the 2020 calendar year.
In the provision to make a withdrawal, the 10% penalty for 2020 is waived! Additionally, while the distribution is still considered to be taxable as ordinary income, the taxable amount can be spread out over 3 years.
For example, say someone took out $12,000 in 2020. They could choose to claim all $12,000 as taxable income in 2020, or elect to claim only $4,000 in taxable income in 2020, 2021, and 2022. This option provides huge savings. The waiver of the 10% penalty alone is great, but the option to spread out the extra income and not have to pay all the tax in one year is even better. That could even mean possibly avoiding a higher tax bracket in the current year!
An even better option
As was mentioned earlier, taking an early distribution from a retirement plan is generally not recommended. Here at Concinnus, we can't stress enough the importance of building emergency savings (personally, and for businesses) for life's curve balls. However, certain circumstances might have given no other option.
One of the best provisions from the CARES Act, though, is that you also have the option to re-contribute the amount you took out in 2020. And you have until 2022 to do so. For instance, say you took out $9,000 from an IRA in 2020. You decide to claim $3,000 of income from it for 2020 and 2021. In 2022 you can decide to pay back that distribution and put all $9,000 back. Currently the contribution limit for an IRA is $6,000. You could then theoretically contribute the $6,000 for that year, and pay back the $9,000. In doing so, the $9,000 would no longer be taxable according to the CARES Act. You can then amend your 2020 and 2021 tax returns and get a refund for the tax paid on the income claimed from the distribution in that year.
While paying back a large amount might seem impossible right now, the provision is worth thinking about. Times are tough, but any amount put back into a retirement account in the next couple years can be claimed to counter the taxable distribution. Doing so would not only refund the tax paid on that amount but get you that much closer to paying your future self back.