14 Jul Is this 401(k) withdrawal tax-free because of the CARES Act?

Q. In 2019, my wife, 67, withdrew $40,000 from her 401(k) to pay off a student loan owed by one of our children. I understand this becomes taxable income. Did the CARES Act affect this treatment in any way?
— Hoping for relief

A. The CARES Act offered some help for certain retirement distributions, but not all.

The Act made several changes related to distributions from retirement plans.

First, it waived or suspended the annual Required Minimum Distribution (RMD) requirement for those individuals who normally would have been required to take an RMD in 2020.

It is important to note the RMD waiver applies to everyone whether directly impacted or not by the coronavirus, said Michael Maye, a certified financial planner and certified public accountant with MJM Financial in Gillette.

“For individuals who had already taken their RMDs and would like to undo them there is potentially some relief,” Maye said. “The distribution can be rolled over into an IRA or an eligible retirement plan within 60 days of the distribution.”

The IRS announced on June 23 that it was broadening the relief for distributions taken during 2020, he said.

“The IRS has extended the 60-day period to Aug. 31, 2020 for any RMDs taken earlier during 2020,” he said. “Previously, RMDs taken in January 2020 were excluded from relief and the RMD needed to be rolled back by July 15.”

Also note this doesn’t apply to inherited IRAs and you are only allowed to have one 60-day rollover per year, he said.

The CARES Act also provides a benefit for coronavirus-related distributions that were taken in 2020 from a deferred retirement account such as a 401(k) or an IRA.

“First, the Act allows individuals below the age of 59 1/2 years old to take up to $100,000 and avoid the normal 10% penalty for an early withdrawal during 2020,” he said. “They would still be on the hook for ordinary income taxes just not the 10% penalty.”

However, he said, the ordinary income tax liability would also be allowed to be spread over a three-year period.

If the distribution is paid back within three years, the taxpayer can file amended tax returns and get all the taxes paid on the distribution, he said. However, a taxpayer must qualify for the coronavirus-related distribution relief. Two such qualifying reasons include having been diagnosed with COVID-19 yourself or having a spouse or dependent diagnosed with COVID-19, he said.

For further detail see IRS Notice 2020-50.

Now to your case specifically.

“Unfortunately, since your wife took the distribution during 2019, she does not qualify for any relief under the CARES Act,” Maye said. “As a result, the income will be 100% taxable as ordinary income in 2019.”

As a future planning point, Maye said, if after-tax money was available, it might have made sense to use those dollars first because it might have lowered the tax liability.

“In addition, the extra $40,000 of income might result in other unwanted tax consequences such as increasing taxability of Social Security benefit(s), potential Medicare Part B and D premium surcharges, and loss of the New Jersey retirement income exclusion if income exceeds $100,000,” he said.

More importantly, how does giving away $40,000 impact your projected retirement?

“When making financial moves such as this, it makes sense to do so through a lens of what are the implications taking into account all the moving parts such as retirement sustainability and taxes,” he said.

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This story was originally published on July 14, 2020.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.