The CARES Act, enacted in the early days of the COVID-19 pandemic, waived the 10% early distribution penalty for so-called “coronavirus-related distributions” from eligible retirement plans in 2020. Many people took advantage of this life raft during the pandemic. But the distributions are subject to income tax if you don’t repay them. Here’s critical tax guidance to consider if you took these distributions.

Eligible Distributions

The CARES Act permitted qualified individuals to withdraw up to $100,000 from eligible retirement plans, including 401(k)s, 403(b) plans and IRAs. Even if your employer doesn’t treat a distribution as coronavirus-related (for example, if the employer treats it as a required minimum distribution), the CARES Act provides that you can treat it as such on your federal income taxes if:

• You were diagnosed with COVID-19,
• Your spouse or dependent was diagnosed with COVID-19, or
• You experienced adverse financial consequences as a result of:
  • being quarantined, furloughed, laid off or having work hours reduced due to COVID-19,
  • being unable to work due to lack of childcare because of COVID-19, or
  • closing or reducing hours of a business you own or operate due to COVID-19.

The IRS has added several other categories of individuals who are eligible for the favorable tax treatment of distributions taken in 2020. So a withdrawal that didn’t seem to qualify as a coronavirus-related distribution at the time may qualify now.

Repayment Options

You generally can repay all or part of the amount of a distribution as long as you do so within three years of the date you received it. In the case of multiple distributions, each has its own three-year repayment period. If you opt to repay a distribution, the repayment will be treated as if it were a rollover contribution — in other words, you won’t owe federal income tax on the distribution.

You’ll need to file amended tax returns if you make the repayment decision in 2022 or 2023. That’s because, without repayment, the distributions generally are included in a taxpayer’s income on a prorated basis over a three-year period, starting with the year the distribution was received.

Say you received a $60,000 qualified distribution in 2020. You generally would report $20,000 in income on your federal tax return for 2020, 2021 and 2022. If you decided in November 2022 to repay the full amount, you would need to file amended federal tax returns for 2020 and 2021 to claim a refund of the tax attributable to the prorated amount you included in your income those years. Similarly, if you opted to include the entire amount in your income for the year of the distribution, you’ll need to amend your return to claim the refund.

Important: If you repaid the distribution in February 2022, before you’ve filed your 2021 tax return, you would need to amend only your 2020 return. Keep such timing considerations in mind when you’re mulling repayment of a qualified distribution to reduce the hassle involved in amending tax returns. You also might want to extend your tax return filing date to October to give you more time to weigh the decision.

Special Circumstances

An important caveat is that your employer doesn’t have to allow repayment of COVID-related distributions. For example, if the plan doesn’t normally accept rollovers, the employer may choose not to change its plan provisions to permit repayment. But an employer must be consistent in its treatment of such distributions. If it permits one employee to repay his distribution, it also must permit other borrowers to repay their distributions.

What if you’ve left that employer? You can repay your distribution if the plan accepts rollovers from former employees. If not, you can rollover the distribution into an IRA.

Decisions, Decisions

Taxpayers who received coronavirus-related distributions should consider several factors, including current and expected financial status, when determining the best strategy for handling them. Our tax specialists can help you make that determination.