14 Oct Will the IRS know if I’m truthful about early 401(k) withdrawals?

Q. I’m 55, in the airline business, and have a healthy 401(k). It seems like everyone in my workplace is taking out money from their 401(k)s to pay off debts and mortgages and even to buy property. None of them are affected by COVID-19 like the rules say you have to be. I am not affected either, but I’m afraid if I take out money, I would be the one audited by the IRS and have no COVID-19 proof. If I decide to do this, is there a risk they will come after me? I want to use the money to get my kids through college.
— Nervous

A. We’re glad you’re asking before acting.

The rules you’re referring to provide for an exception to the 10% penalty for early withdrawals from a qualified retirement plan due to coronavirus-related distributions up to $100,000. It’s part of the CARES Act.

First, let’s address “none of them are affected by COVID-19.”

“I want to make sure that you understand what the rules say about being `affected’ by the virus,” said Laurie Wolfe, a certified financial planner and certified public accountant with Lassus Wherley, a subsidiary of Peapack-Gladstone Bank, in New Providence.

You indicated that you and your fellow workers are in the airline business — a business that’s been hard hit by the pandemic, she said.

According to the rules, being affected by the pandemic can mean anything from losing your job, being furloughed, having reduced work hours or reduced pay. These are in addition to the other qualifications which can include whether you, your spouse or any of your dependents were diagnosed with the disease, whether you or they experienced financial consequences as a result of being quarantined or were unable to work due to a lack of childcare, Wolfe said.

It would even include whether your spouse or a member of your household had a job offer rescinded or a start date for a job delayed due to COVID-19 or whether one of you experienced a closing or reduction in hours of a business owned or operated by you or them, she said.

“You may not realize that your co-workers qualified for this relief in a way other than them having COVID-19 or losing their job,” Wolfe said. “Maybe their recent college graduate, who lives with them, lost their offer of employment.”

Once you take a look at all of that and you still decide that you and your household members have not been affected by COVID-19, as defined by the IRS for this purpose, you are wondering if you should roll the dice and do it and what your risks are with respect to the IRS coming after you.

“As the means for documenting your qualification for being exempt from the 10% penalty for early withdrawal from a retirement plan you will be asked to complete and sign a Form 8915-E Qualified Disaster Retirement Plan Distributions and Repayments,” Wolfe said. “Although this form is not yet available for 2020, I imagine that it’s going to ask you to check a box or in some manner attest to what entitles you to this relief.”

Wolfe said you should not make fraudulent statements and file them with your tax return.

So what are the chances you would get looked at??

“The IRS in the past has picked certain things and gone after them aggressively,” Wolfe said. “For example, there were a few years in the not too distant past that they were sending out automatic notices to anyone who took distributions from Section 529 plans. Taxpayers had to submit their receipts to prove that the distributions were made in order to pay qualified education expenses.”

Don’t forget that the distributions are still subject to ordinary federal and state income taxes, Wolfe said.

You can pay the federal income tax on a qualified distribution for COVID-19 over the course of three years, with at least one-third each being paid in the first two years. You can also pay it all in one year if you desire, she said.

“Paying the taxes sooner than later will not change the risk that the IRS will ask for substantiation,” she said.

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This story was originally published on Oct. 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.