One of the provisions of the CARES Act that was enacted in late March 2020 provides income tax breaks for individuals affected by COVID-19 who take “coronavirus-related distributions,” or CRDs, from a company plan or from an IRA in 2020. Company plans aren’t required to offer CRDs.
Tax Breaks for Coronavirus-Related Distributions
If a distribution qualifies as a CRD, the recipient is entitled to the following three tax breaks on up to $100,000 of retirement plan distributions:
- The 10% penalty is waived.
- Tax on the distribution is due, however, it can be spread evenly over three years.
- The funds distributed can be repaid over the three-year period to a company plan or IRA with a refund of taxes paid.
Affected individuals who qualify for CRDs fall into three categories as follows:
- You are diagnosed with the virus SARS-CoV-2 or with COVID-19 by a test approved by the Centers for Disease Control and Prevention.
- Your spouse or dependent is diagnosed with the virus by an approved test.
- You experience “adverse financial consequences” as a result of being quarantined, being furloughed or laid off or having work hours reduced, being unable to work due to lack of childcare, or closing or reducing hours of your business.
IRS Notice 2020-50 provides additional guidance and clarification regarding adverse financial consequences that can qualify affected individuals for CRDs.
Section 72(t) Relief
Although the “adverse financial consequences” criteria for individuals is fairly broad, if you, your spouse, or dependent aren’t diagnosed with the virus SARS-CoV-2 or with COVID-19, it’s possible that you may not qualify for the CRD tax break.
If this is the case, there’s another strategy that you can use to avoid the 10% federal penalty and a potential state penalty on premature distributions from retirement plans. It works for individuals who are less than 59-1/2 who own an IRA or have a company plan and employment has been terminated with that company.
The strategy, which is commonly referred to as “72(t)” for the IRS Code section that created it, requires you to commit to a plan of withdrawals, or “substantially equal periodic payments,” or SEPPs. The 72(t) strategy has been blessed by IRS since 1989 when it was added to the Internal Revenue Code.
Section 72(t) Requirements
To take advantage of Section 72(t), payments are required to be distributed from a retirement plan using an annuitization method that:
- Must continue for the longer of five years or until age 59-1/2,
- Must be distributed at least annually using either a calendar or fiscal year depending upon the annuitization method chosen,
- Must be substantially equal with no change in the payment formula and no stoppage of payments unless the account owner becomes disabled or dies,
- Can be calculated using either a single or joint life and cannot be changed.
Section 72(t) Annuitization Methods
There are three annuitization methods authorized by IRS, however, other distribution methods can be used if they satisfy the SEPP requirement. The three authorized methods are as follows:
- Minimum distribution
- Annuity factor
The minimum distribution method will generally result in the lowest payment. The amortization and annuity factor methods generally produce larger distributions since both allow you to use a “reasonable” interest rate to calculate the payments.
While it’s possible to make a one-time irrevocable change from either the amortization or annuity factor method to the minimum distribution method, you are otherwise locked into the method that you choose when you establish your 72(t) plan. The choice of a specific method will depend upon your retirement income planning needs.
Section 72(t) Plan Modification Consequences
The most important consideration when deciding whether to implement a 72(t) plan is your ability to stick to it. A minimum commitment of five years from the date of establishment of a plan, or until age 59-1/2, if longer, is required. Assuming you’re 45 when you set up your plan, you would need to maintain it for 14 years until you turn 59-1/2.
The consequences of not sticking to a 72(t) plan can be expensive. This is because the 10% federal and applicable state premature distribution penalty and interest will be applied retroactively to all distributions taken before age 59-1/2 in the year in which a plan modification occurs.
There are several types of Section 72(t) modifications. These include missed distributions, reduced distributions, excess distributions, and changes in the account balance to calculate the distribution amount other than by regular gains and losses. In addition, funds cannot be added to the 72(t) account, including contributions or rollover of distributions.
As an example, let’s assume that Tom began his 72(t) plan when he was 45, he is now 57, and he has taken allowable distributions totaling $220,000 from his 72(t) IRA account over the last 12 years. Suppose that his calculated 72(t) distribution amount at age 58 is $23,000, however, Tom takes $40,000 since he needs extra money for home improvements. Tom has modified his 72(t) plan by taking excess distributions of $17,000. He will be assessed a federal penalty of 10% of $260,000 (prior year distributions of $220,000 + current year distribution of $40,000), or $26,000, plus any applicable state penalty and interest in addition to current year tax liability on his distribution of $40,000.
In addition to assessing your ability to stick to a 72(t) plan, it’s important to decide on the amount of funds that you want to commit to your plan at the outset. This requires projections of the 72(t) plan account balance over the duration of the plan life and continuing throughout retirement using various distribution methods.
Since the financial consequences of a 72(t) plan modification can be significant, you should only transfer enough funds to a 72(t) IRA account that will meet your projected annual needs for the duration of the plan using your selected distribution method. Any excess funds should remain in a separate IRA account.
While tax breaks are available for Coronavirus-Related Distributions (CRDs) and 72(t) distributions, both are short-term solutions resulting in premature distributions from company plans or IRAs. Premature distributions disrupt tax-deferred growth of taxable retirement plans. Both strategies require payment of income tax although it can be spread over three years with CRDs. Furthermore, funds withdrawn won’t be available for retirement when they may be needed the most.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.