17 Feb Can I use a COVID withdrawal to invest in a Roth IRA?

Q. I took out $30,000 from an old 401(k) in August. I don’t have any U.S. earned income for the year because I live abroad. I know I can pay the tax from the withdrawal over three years and avoid taxes because $10,000 per year will be less than the standard deduction. But my 401(k) withheld $6,000 for taxes, so I’d like to claim the withdrawal in one year instead of three to get that $6,000 back. I don’t usually qualify for a Roth because of my income, but can I redeposit say $20,000 from the withdrawal into a Roth or am I limited?
— Trying to save

A. There are a few things to unpack here.

First, if you don’t intend to pay the $30,000 back, as you noted, you could spread the distribution over three years but you don’t have to.

“Since $6,000 was withheld in 2020 you would report the $6,000 on your 2020 income tax return,” said Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton. “By doing so you would receive a refund back for 2020 as you suggest.”

As for the Roth IRA question, it looks like you would like to return $20,000 of the $30,000 withdrawn to a Roth IRA.

Unfortunately you cannot roll the money back to a Roth IRA, Hook said. You can roll it back to an IRA or your 401(k), he said.

You may still be able to get the funds into a Roth IRA by doing a Roth IRA conversion of the funds once returned to the IRA, Hook said.

“With Roth IRA conversions you do pay tax on the amount converted so if you converted $20,000 to a Roth IRA, you would pay income tax on the amount of the $20,000 that was taxable after your standard deduction,” he said.

Hook offered this example: If you file as a single taxpayer and you converted the $20,000 to a Roth, you would have taxable income of approximately $7,450 — $20,000 less standard deduction of $12,550. Tax owed would be 10% or $745, he said, noting that Roth conversions are reported in the year of conversion so if you did the $20,000 in 2021 it would be reported in 2021.

“The overpayment of the $6,000 withheld would be in 2020 – you can deal with this when filing your 2020, not asking for the full $6,000 back as a refund,” he said. “Instead ask for $5,255 back as a refund and have $745 applied to the 2021 tax return. This way you have covered the tax on the amount converted when filing your 2021 return.”

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This story was originally published on Feb. 17, 2021.

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