photo by Pixabay user NataliSamorod
If you took a required distribution from a retirement plan or individual retirement account earlier this year, a specially extended opportunity to put it back – and to skip an otherwise mandatory distribution in 2020 – will expire on Monday.
Generally (but only very generally), when given a choice between paying taxes now and paying taxes later, the correct answer is “later.” Like so many other features of ordinary life, however, the usual principles don’t work very well in this peculiar, political, pandemic-stricken year. The same relief legislation that waived mandatory distributions in 2020 created other opportunities, as well as potential pitfalls, for managing retirement funds.
A lot of the decision-making boils down to three questions. First, did COVID-19 affect your life in some significant way – through illness in your household, disruption to your occupation, or the loss of child or dependent care that enabled you to work? If it did, you are a “qualified individual,” eligible to avail yourself of some of the liberalized rules. Even if the pandemic did not affect you this way, if you reached age 70 1/2 or older in 2019, you still can take advantage of the one-year waiver of required minimum distribution you would otherwise have been forced to take in 2020. (Under pre-pandemic law, the beginning age for required minimum annual distributions recently rose to 72, but only for those who were not 70 1/2 before the end of 2019.)
This, believe it or not, is the simple part. At least the answers to this first question are knowable.
The second question is whether your income is likely to be significantly higher in 2021, or later years, than it is in 2020. For a lot of people, it would be hard to imagine that next year will be worse than this one, when COVID-19 took the world by surprise. Certainly there is reason to be optimistic, but there is no reason to be certain. Still, an educated guess here can help shape your decision. If your income is likely to be higher later, when retirement distributions could fall into more punishing tax brackets, then you might be better off taking some money out now.
Finally, what will the tax law look like in 2021 or later years? This, too, is anybody’s guess. We know a few things right now: The House of Representatives seems very likely to stay in Democratic hands. The Senate could plausibly move to Democratic control (and Democrats seem eager to eliminate filibuster rules so they can pass legislation without Republican support). Joe Biden has had a consistent lead in the presidential election polls. We also know that the pandemic decimated many state budgets. At both the federal and state levels, tax rates may rise considerably in 2021 and later years, particularly for higher-income households.
So if you took a distribution from a retirement plan in 2020, whether it was required or not, paying taxes on it under this year’s rates may not be a bad outcome. If your distribution of up to $100,000 qualifies as COVID-related, you also have the option of spreading the tax on it over a three-year period running from 2020 to 2022. You won’t face the 10% additional penalty tax on premature distributions if you are under age 59 1/2 as long as your withdrawal in 2020 was COVID-related. And, as long as the withdrawal was not a required minimum distribution, you generally have up to three years to put the money back into a retirement account and not pay tax on it at all.
With so many questions and so few answers, what are you supposed to do if you took a required distribution and you now face that Monday deadline to put it back?
Absent unusual factors like losses from business operations this year, and if I had the cash to spare, I would put it back into the retirement plan. Yes, tax rates may go up next year. Putting the money back in the retirement account will also increase the amount of next year’s mandatory withdrawal, though generally not by very much. But even savers past age 70 could benefit from many future years of tax-deferred growth. So could their heirs (albeit to a limited extent, other than for spouses).
However, if I were cash-strapped for COVID-related reasons this year, I would give serious thought to tapping retirement accounts. (That is, if my employer agreed; some have not amended their plan operations.) In this scenario, I could take advantage of the liberalized rules for early distributions, extended rollover periods, spread-out taxation and more generous plan loans.
Bear in mind that retirement plans serve an important long-term purpose – it’s called retirement – so don’t just take the money to socially distance yourself on a beach in the South Pacific. But 2020’s special rules could be an excellent opportunity to get out of a credit card debt hole, or to tap funds for a down payment on a house, or to move to an area with better schools or professional options.
Our COVID-19 roller coaster ride is far from over. Keep your seat belt fastened, and be ready for some sharp curves ahead. You might have one of them coming up in a few days.