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Time running out to repay COVID retirement distributions, recover paid taxes

Cracked nest egg iStock_000009519883Small-1

Three years ago, the COVID-19 pandemic shut down summer. It wasn't just recreational activities that took a hit. Lots of people lost income, even their entire jobs, as businesses closed to help slow the coronavirus spread.

Several laws were enacted to help companies and individuals deal with the financial problems created by COVID and our response to it. One of the early ones was the Coronavirus Aid, Relief, and Economic Security (CARES) Act, a $2 trillion relief package that took effect on March 27, 2020.

Now, many people are facing a deadline in connection with one of the CARES Act's financial support provisions.

Bridge money from retirement plans: The CARES Act allowed retirement savers to withdraw up to $100,000 in 2020 from their 401(k) plans and individual retirement accounts to help them cover financial shortfalls due to the pandemic.

These coronavirus-related distributions, or CRD, were allowed, for the 2020 tax year only, for affected individuals who —

  1. were diagnosed with COVID-19 by a CDC-approved test,
  2. had a spouse or dependent who was diagnosed by a CDC-approved test, or
  3. experienced adverse financial consequences due to quarantine; layoff, furlough, or reduced hours; inability to work because of lack of child care; closure or reduced hours of a business owned by the individual due to the virus; or other reasons identified by the Treasury Department.

Essentially, it offered a financial bridge for those who had no other way to make up income lost during the start of the pandemic.

Tax relief, too: The CARES Act also created a variety of tax breaks in connection with CRDs.

Any withdrawn money was still taxable at ordinary income tax rates. However, the 10 percent tax penalty usually assessed on early withdrawals from tax-deferred retirement accounts — it typically applies to money taken out by someone younger than 59½ — was waived.

And the CARES Act also provided a way for those needing the money to recover those taxes later. All they had to do was repay the distribution amount, in part or full, within three years.

Putting the withdrawal amount back into a retirement plan or account meant the distribution essentially was a tax-free loan.

Time frame key: The critical clause here is the three-year time frame. Miss that deadline and there's no recovering the taxes paid on the 2020 withdrawal amount.

Some IRA and 401(k) owners who tapped their retirement plans via CRDs are facing that deadline.

I hear you. Didn't that deadline already pass on March 27, 2023?

No, because the three-year payback period started when the retirement account holders got the money from their nest eggs. And as anyone who's tried to get money out of a financial account knows, the process takes time.

How much CRD money: A Vanguard Group analysis in December 2020 of its clients' retirement accounts found that the average distribution was $15,700, and the median was $6,500.

However, nearly one-third of participants who used the special COVID retirement withdrawal option took multiple distributions. That pushed the average participant distribution to approximately $24,600, with a median of $13,300.

Nearly one in four participant distributions were for less than $5,000, according to Vanguard's data, with 60 percent of all withdrawals for less than $20,000. Withdrawals of more than $30,000 were less common, with only 4 percent of participants who took a CRD withdrew the $100,000 maximum.

The average Vanguard account distribution, based on the percentage of a participant's balance, represented 55 percent of a participant's total balance. About a quarter of distributions were for nearly all or 100 percent of the account balance. One-half of withdrawals were for less than 50 percent of their balance.

Even with the tax break, that was a lot of retirement money subject to federal tax.

Pay soon or lose out: If you still have some time ticking on your three-year repayment clock, get to it. As for the repayment itself, you have some flexibility. You don't have to put the money back into the account you originally tapped.

That's good news for many, since in the pandemic's aftermath, a lot of people have left the jobs where they had the CRD 401(k). Also, COVID-related money taken from a 401(k) can be returned to an IRA.

The same is true for IRA repayments. A CRD from an IRA in 2020 can be repaid to another IRA.

Getting a repayment refund: Now about those taxes you paid on your CRD. You'll need to file an amended tax return using Form 1040-X to claim your refund of them.

It also may take several amended filings, as the Internal Revenue Service's special CARES Act CRD frequently asked questions page. The CARES Act allowed CRD recipients to spread the distribution's taxes over a three-year period, with (2020, 2021, and 2022). A lot of plan owners did that since they didn't want (or couldn't afford) the immediate tax bill on the full CRD.

IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs), has some CRD repayment information for taxpayers. Consulting a tax adviser also is a good idea.

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