What happens to 401(k) withdrawals under the CARES Act?

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Q. I took an early withdrawal from my 401(k) because I was financially affected by the coronavirus. I didn’t have the virus and neither did my family, but I went on a medical disability from mid-April until now. Prior to my disability, my work hours significantly decreased. I used my paid leave hours so I got a regular paycheck, but now I’ve exhausted that. Would my situation qualify for the CARES Act so I’m not penalized for the 401(k) withdrawal?
— Struggling

A.  The CARES Act was passed in March.

It provides many benefits, including relief from penalties for early distributions.

It affects those under age 59 ½ who between Jan, 1, 2020 and Dec. 31, 2020 take distributions of up to $100,000 from their IRA or 401(k) plan if they meet certain criteria, said Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton.

The original criteria in the Act was updated on June 19 by the IRS (Tax Notice 2020-50) and as of now, Hook said, the following criteria needs to be met for penalty relief:

  • Taxpayer or spouse or dependent is diagnosed with COVID-19 by a test approved by the CDC or
  • Someone who has experienced financial consequences due to the taxpayer, spouse or member of the household being being affected in one of the following ways:
  • Being quarantined, furloughed or laid off
  • Unable to work due to lack of childcare due to COVID-19
  • Closing or reducing hours of a business they owned
  • Reduction in pay or self- employment income reduced due to COVID-19
  • Having a job offer rescinded or delayed starting date due to COVID-19

In addition to the clarifications in Tax Notice 2020-50 is the certification as to whether or not a taxpayer qualifies for penalty relief, which rests solely with the taxpayer.

“In other words, your 401(k) plan provider will not require any documentation such as a positive test result, for example, to code the distribution as being exempt from the penalty,” Hook said.

But, Hook said, this does not mean that you won’t need to provide documentation to the IRS if you’re asked to do so.

Hook said the tax document that will be provided to you at the end of the year may not indicate that you are exempt from the penalty. It will be up to the taxpayer to make sure it is properly recorded on their tax return, he said.

But there are a few important things to remember.

“Federal and state tax are still due on the distribution,” Hook said. “The only thing being waived is the 10% early withdrawal penalty.”

Also, you can elect to spread the taxes on the distribution over three tax years, which could reduce the income tax you owe and will delay the payment of the tax, he said.

And, Hook said, you can pay back the distribution and pay no taxes if done so within three years from the date you receive the distribution if your financial situation improves.

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This story was originally published on July 28, 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.