August 17, 2021
If you were adversely affected by the COVID-19 pandemic, you may have taken a tax-favored coronavirus-related distribution (CVD) from a traditional IRA last year. This privilege was allowed under the CARES Act, which was signed into law on March 27, 2020. What steps can you take now to achieve the optimal federal income tax results?
Under the CARES Act, if you were eligible, you could take one or more CVDs from one or more traditional IRAs in 2020, up to a combined limit of $100,000.
Then you can recontribute all or part of any CVD amount back into one or more IRAs within three years of the distribution date of the CVD. You can treat each distribution and later recontribution as a federal-income-tax-free IRA rollover transaction. This favorable tax treatment applies equally to CVDs taken from traditional IRAs, SEP-IRAs and SIMPLE-IRAs.
There are no restrictions on the use of CVD funds. You can use the money to pay bills or help your adult kids and then recontribute within the three-year window. Or you can keep the CVD money and pay the resulting tax hit, which may be modest depending on your circumstances. So, a CVD can be a useful cash-management tool.
Treating an Eligible Distribution as a CVD
If you took a CVD from a traditional IRA last year, you should have received from the custodian or trustee a 2020 Form 1099-R that reported the distribution. The IRS also received a copy. So the IRS knows what happened.
To treat an eligible IRA distribution as a CVD, IRS Form 8915-E should have been included with your 2020 personal federal income tax return. If you extended your 2020 return, you should include this form when you file by October 15. If you’ve already filed your 2020 return without the form, you’re out of luck. The election to treat a distribution as a CVD can’t be made or changed after the timely filing (including any extension) of your 2020 tax return.
Beware of Certain Tax Consequences
If you recontribute an IRA CVD amount within the three-year window, the ultimate result is the same as a federal-income-tax-free rollover transaction for that amount. However, you may have to put up with awkward interim tax consequences before you arrive at the favorable tax-free-rollover-equivalent outcome.
Specifically, the three-year ratable inclusion rule is the default method for how CVDs are taxed. Under that method, the taxable portion of a CVD is spread equally over 2020, 2021 and 2022. So, if you took a $90,000 CVD last year, you would report $30,000 per year on your personal tax returns for 2020, 2021 and 2022. If you don’t recontribute any of the CVD amount within the three-year window, those tax results would be the final outcome.
Examples of Interim Tax Consequences
If you took several CVDs from one or more IRAs (up to the $100,000 combined limit), the interim tax consequences apply separately to each CVD.
For example, Zoe took a $90,000 CVD from her traditional IRA in 2020. The $90,000 would be fully taxable under the regular federal income tax rules. After recontributing the entire $90,000 sometime in 2023, before the three-year window closes, she must file amended returns for 2020, 2021 and for 2022 if she already filed her 2022 return to recover the interim federal income tax hits for those years. At the end of the day, the CVD is federal-income-tax-free, but Zoe had to jump through some hoops to get there.
Xavier also took a $90,000 CVD from his traditional IRA in 2020. He decides to recontribute the entire amount in December 2022, rather than waiting until 2023. So, Xavier won’t be hit with any interim tax for 2022. But he’ll need to file amended returns for 2020 and 2021 to get back the interim tax hits for those years based on the $30,000 that was included in income on his tax returns for each of those years. Once again, the CVD ultimately turns out to be federal-income-tax-free.
Alternatively, these taxpayers could report the entire $90,000 CVD as income on their 2020 tax returns. They would pay the entire interim tax hit with their 2020 returns. Assuming they recontribute all or part of the $90,000 within the three-year window, Zoe and Xavier would need to file an amended 2020 return to get back all or part of the tax hit for that year.
Important: You must treat all the taxable income from CVDs received in 2020 the same way. Either report all the income using the three-year ratable income inclusion method or report all the income on your 2020 tax return. You can’t mix and match these methods.
How to Handle Recontributions
If you recontribute all or part of any CVD amount by the due date of your 2020 federal income tax return (including any extension), don’t report the recontributed amount as income on your 2020 return. But you must include Form 8915-E to report your recontribution.
If you recontribute all or part of any CVD amount after the due date of your 2020 federal income tax return (including any extension), file an amended 2020 return to remove the recontributed amount from your 2020 income and recover the related tax hit for 2020. The amended return must include Form 8915-E to report the recontribution.
As explained earlier, you can spread the income from 2020 CVDs equally over three years, starting with 2020. If you then recontribute any CVD amount within the three-year window before the due date of your federal income tax return for the year of the recontribution (including any extension), the amount of the recontribution reduces the ratable income inclusion amount that’s reported on that year’s return.
For example, suppose you took a $75,000 CVD from your traditional IRA in 2020. You use the three-year ratable income inclusion method to report the CVD income as follows:
- $25,000 in 2020,
- $25,000 in 2021, and
- $25,000 in 2022.
On April 10, 2022, you recontribute $25,000. On April 15, 2022, you file your 2021 federal income tax return. The recontribution reduces the amount that must be reported as CVD income for 2021 from $25,000 to $0. Assuming no further recontributions within the three-year window, you must still report $25,000 of CVD income on your 2022 return.
So, when all is said and done, you report $25,000 of CVD income in 2020, recontribute $25,000 in 2021 and report the last $25,000 as income in 2022.
No Recontribution Privilege for Inherited Accounts
Beneficiaries of inherited traditional IRAs can receive CVDs if they’re eligible individuals, and they can follow the three-year ratable inclusion rule to report taxable income from CVDs or they can report the entire amount with their 2020 returns. In either case, their CVDs are exempt from the 10% early distribution penalty tax. However, CVDs received by beneficiaries of inherited traditional IRAs (other than the surviving spouse of the IRA owner) can’t be recontributed per IRS Notice 2020-50.
What’s Right for You?
The optimal CVD strategy depends on your specific circumstances.
For instance, if your 2020 taxable income was much lower than usual due to the COVID-19 economic fallout, there might be only a modest federal income tax hit from CVD income reported in 2020 under the three-year ratable inclusion rule. In this situation, if you took a CVD in 2020, you have extra cash in hand and can eventually get back any interim tax hits for CVD amounts that you recontribute within the three-year window.
If you had negative 2020 taxable income because of business losses due to the COVID-19 economic downturn, it might be a good idea to report all the CVD income on your 2020 return. You may be able to shelter most or all that income with business losses. In this situation, you have extra cash in hand and will owe little or no extra federal income tax for 2020. If you have sufficient cash later, you can recontribute all or part of any CVD amount within the three-year window. You’ll recover all or part of any extra 2020 tax hit from the CVD — and you’ll get the recontributed amount back into tax-favored IRA status.
If you extended your 2020 federal income return, you have until October 15, 2021, to make decisions that will determine how any CVD amount that was not already repaid last year will be taxed.
CVDs from Retirement Plans
If your company retirement plan allowed CVDs to be taken last year, the tax rules and implications are similar to those for CVDs taken from traditional IRAs, as explained in this article.
Bottom line: The follow-up on tax-favored CVDs taken in 2020 requires careful consideration. For more information about your specific tax situation, contact your tax provider or submit a question to the GRF CPAs & Advisors tax team.