401k Penalty for Early Withdrawal
Robert Aufseeser

Section 2202 of the CARES Act, enacted on March 27, 2020, contains special rules governing the taxation of 401k withdrawals. Certain tax relief is available for early withdrawals used for coronavirus-related purposes.  Essentially, the CARES Act eliminates the 10% early withdrawal penalty for certain distributions taken from retirement plans such as 401(k) and 403(b) plans, and IRAs. Normally, if you are younger than 59 1/2 years and you withdraw money from your retirement account, you will be hit with a 10% early withdrawal penalty.

The favorable tax treatment applies to a distribution of up to $100,000 from an eligible retirement plan made on or after January 1, 2020, and before December 31, 2020.

However, to receive favorable tax treatment, the law requires the taxpayer to meet certain criteria. In other words, if you take a distribution or loan of say $45,000 on June 1, 2020 and you don’t meet the requirements, you are going to be hit with a big tax bill along with a 10% early withdrawal penalty.

You qualify for COVID-19 Tax Relief if you made a withdrawal because:

  • You were diagnosed with SARS-CoV-2 or with coronavirus disease 2019 (COVID-19)
  • Your spouse was diagnosed with SARS-CoV-2 or with coronavirus disease 2019 (COVID-19)
  • You experienced adverse financial consequences as a result of being quarantined, furloughed, or laid off, due to SARS-CoV-2 or COVID-19
  • You experienced adverse financial consequences as a result of being unable to work due to lack of child care due SARS-CoV-2 or COVID-19
  • You experienced adverse financial consequences as a result of closing or reducing hours of a business that you own or operate due to SARS-CoV-2 or COVID-19

If you meet any of these criteria, and you have evidence supporting your claim, you can file a statement with your tax return in the year the 1099-R is issued reporting the distribution.

The CARES Act does not allow you to avoid paying income taxes

If you keep the money and don’t repay it, you must recognize the income from the distribution ratably over a three-year period. For example, if you receive a $30,000 coronavirus-related distribution in 2020, you would report $10,000 in income on your federal income tax return for each of 2020, 2021, and 2022. However, you have the option of including the entire distribution in your income for the year of the distribution.

However, you will escape the 10% early withdrawal penalty.

Can I pay it back?

Yes, the law allows you to repay all or part of the amount distributed from an eligible retirement plan if you complete the repayment within three (3) years of the date you received the distribution.

For example, let’s say you receive a coronavirus-related distribution of $90,000 in 2020 and you choose to include the distribution amount in your income over a 3-year period ($30,000 in 2020, $30,000 in 2021, and $30,000 in 2022). However, in 2022 you choose to repay the full amount and your plan allows the repayment. If you make the repayment, you are allowed to amend your federal income tax returns for 2020 and 2021 to claim a refund of the tax attributable to the amount of the distribution that you included in income for those years, and you will not be required to include any amount in income in 2022.

How does the plan (or IRS) know if I qualify for tax relief under the CARES Act?

Generally, a plan administrator may rely on your certification that you meet the requirements for relief under the CARES Act. But your certification may not be sufficient if the IRS challenges your position. Be prepared to substantiate your claim with evidence of a positive COVID-19 test, or with financial information showing the hardship caused by the pandemic. As with any other tax position, if you can’t substantiate the position, you shouldn’t take it in the first place. You are only entitled to treat the distribution as a coronavirus-related distribution for purposes of your federal income tax return if you actually meet the eligibility requirements.

I’m Being Audited, Now What?

The tax relief contained in Section 2202 of the CARES Act is evolving. For example, tax practitioners expect the IRS to issue guidance expanding the list of criteria for determining a valid coronavirus-related distribution. If you’re being audited, do not ignore those IRS letters. Contact a tax attorney to better understand your options.