If you took a COVID-19 related distribution from your retirement account in 2020, you're certainly not alone—but you might get a surprise at tax time.
The CARES Act, signed into law by former President Donald Trump last year, allowed those under age 59.5 who were adversely affected by COVID-19 to withdraw up to $100,000 from a retirement account without having to pay a 10% early withdrawal penalty. The withdrawals had to occur between January 1 and December 31, 2020. In addition to 401(k)s, the distribution could also come from individual retirement plan accounts (IRAs), according to Brandy Marion, manager of retirement plans education at BOK Financial®.
Qualified individuals included those who have, or whose spouses have, been diagnosed with COVID-19, as well as those who experienced adverse financial consequences caused by the pandemic, Marion explains. Those "adverse financial consequences" included "being laid off, having hours reduced, being quarantined or furloughed," she said.
If you took a COVID-19-related 401(k) loan, it's important to understand the terms. "In addition to ultimately having to pay it back, if you default, the amount that hasn't been paid back will be subject to tax at your ordinary income rate," Marion said.
Normally, 401(k) loans are repaid over a five-year period through payroll deductions. However, the CARES Act gave people "an extra year to pay back their loans if 2020 was one of the five years for their outstanding loan repayment, essentially creating a six-year repayment period with no payments due in 2020," Marion said.
Even paying one-third of the tax obligation now could be difficult for some retirement plan participants who took a COVID-19 related distribution, especially considering that some Americans are still experiencing major blows to their finances.
Overall, 21% of respondents to a January 2021 Pew Research Center survey said that their family's financial situation has worsened in the past year. But many more expect to feel the strain in the long term. Roughly half of the non-retired adults surveyed said that the economic impact from the COVID-19 pandemic will make it harder for them to achieve their financial goals in the long run. Moreover, one in 10 respondents who said their financial situation had gotten worse during the pandemic didn't think their financial situations will ever recover, the survey showed.
Although the prospect of paying more taxes than you must can be a difficult pill to swallow, some retirement plan participants who took a COVID-19-related distribution and experienced a complete or near-complete loss of income in 2020 might want to consider doing exactly that.
"If you expect your taxable income in 2021 and 2022 to be substantially higher, you can opt to treat the entire distribution as taxable in 2020," Marion said. However, people who are contemplating that option should talk with a tax advisor first.
In addition to deciding how to foot the tax bill, those who took a COVID-19-related 401(k) distribution also might have some extra paperwork to consider.
"You also may need to take extra steps to ensure the withdrawal is qualified if the tax form you receive doesn't reflect that," Marion said.
Tax forms for 401(k) distributions
If you took a distribution from an eligible retirement account, you should receive a Form 1099-R that shows the amount withdrawn. The number in Box 7 will determine your next steps.
- If Box 7 says 2, the distribution is coded as a qualified reason.
- If Box 7 says 1, you can fill out Form 8915-E to certify that the distribution should qualify.
Just how many distributions were there?
Through most of the eligibility period, relatively few retirement plan participants opted for COVID-19-related distributions, but numbers sharply increased towards the end of the year.
Overall, BOK Financial experienced approximately a 31% increase in distribution requests in 2020, according to figures from Cheryl Hawkins, retirement plan services manager at BOK Financial. Of the total requests that BOK Financial processed last year, roughly 33% were COVID-19 related, she said.
"In the very beginning, they were coming in fairly slowly," Hawkins recalls of the COVID-19-related requests. "For quite a while, we thought that maybe it wasn't going to be as big a deal for us as we had first anticipated."
Other firms have noted similarly low usage of the provision in the beginning. For example, only 3% of Fidelity's eligible 401(k) and 403(b) plan participants took a CARES Act distribution between April 1 and June 30, according to figures published in a July CNBC report. Likewise, only 3.2% of participants in The Principal's plans had taken a COVID-related distribution by the end of August, according to a September article in InvestmentNews.
However, as the pandemic struggles stretched on, BOK Financial numbers increased dramatically from the summer through the end of the eligible period, according to Hawkins. In December, the month when BOK Financial processed the most distributions, approximately 62% were COVID-related.
Now that the eligibility period for COVID-19-related 401(k) distributions has passed, requests for distributions have somewhat decreased and then normalized, according to Hawkins.
"For January and February, our volumes dropped by around 15% from what we've normally seen during those months in previous years. However, in March, we've jumped back up to normal pre-COVID volumes," she said.
And so, if you have taken a COVID-related distribution from your retirement account, rest assured that, although Uncle Sam will come calling, you don't have to pay those taxes all at once. You have time to get back on your feet again.
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