24 Oct Can I take from a 401(k) to save on taxes from COVID withdrawal?

Q. My husband took a COVID distribution from his 401(k) in December of 2020. It was a big chunk and has increased our tax income bracket by a huge amount. For the first time, we had to pay taxes last year. Now I am quitting my job. Can I roll over part of my 401(k) to pay for part of the distribution?
— Stressed

A. Of course you don’t want to pay more in taxes than you need.

But it’s important to understand the difference between tax liability and taxes owed when you file your return.

First, someone owing or getting a refund at tax preparation time is a truing up of their actual tax liability, said Michael Maye, a certified financial planner and certified public accountant with MJM Financial in Gillette.

“Someone can have incremental income via a 401(k) distribution and not change their tax bracket but still owe additional taxes from having higher income,” he said. “It is also possible to be pushed into a higher tax bracket by taking the 401(k) distribution.”

It’s not clear whether you’re asking if you can take money out of your own 401(k) and use the proceeds to pay back your husband’s COVID distribution or if it’s to pay the incremental income taxes related to the distribution.

To get there, let’s review the COVID distribution rules.

SSection 2202 of the CARES Act allowed for up to $100,000 to be taken out of a retirement plan such as a 401(k), Maye said. Individuals under the age of 59 1/2 years old were also not subject to the 10% early withdrawal penalty for COVID retirement plan distributions.

“Generally, the income is included ratably over a three-year period spreading the tax hit out, which for most people is better than including the full distribution in one tax year,” he said. “Also, the COVID-related distribution may be paid back in full or in part if repayment is made within three years after the date the distribution was received.”

So the first thing to consider is your age.

“If you are quitting your job and don’t qualify for an exception, if you take a distribution from your 401(k) or IRA pre-age 59 ½, you will be subject to 10% early withdrawal penalty plus ordinary income taxes on the distribution,” he said. “So, whether you were asking about paying back your husband’s COVID distribution back or covering the incremental taxes it is likely a less than ideal place to get those funds.”

If you have after-tax money available in a bank account or taxable brokerage account, that might be a better source to either pay back the COVID distribution or pay the related pro-rata taxes over the three-year period, he said.

You mentioned that you will stop working and you mentioned a rollover.

If you leave your employer, generally you can remain in the 401(k) or alternatively roll over the money into a traditional IRA, Maye said. If you leave the money in the 401(k), you will need to check with the plan administrator re: the plan rules on distributions.

“Assuming you rolled over the 401(k) into a traditional IRA, you will be able to take a partial distribution,” he said. “However, the money distributed, assuming all pre-tax contributions, distributions taken are subject to ordinary income taxes.”

Also, if you are under age 59 ½, you will also be subject to the 10% early withdrawal penalty.

So, whichever you are trying to do, it might not make sense for you to increase your taxable income this year, he said.

“I would recommend you have a certified public accountant review your situation to determine whether it even makes sense to pay back the COVID distribution to recoup the incremental taxes from the distribution,” Maye said. “There is a chance it doesn’t make sense as you will be using pre-tax distribution from a 401(k)/IRA and incurring more taxes to pay back COVID distribution itself or taxes related to the distribution over three years if distribution isn’t paid back.“

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This story was originally published on Oct. 24, 2022.

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.