Updated: May 11, 2021
It's never a pleasant thing to find an unexpected 1099-R in the mail, but this year, there is a good chance you have one.
A 1099-R is a tax form sent out from a financial institution, detailing a distribution from an annuity, retirement account, or pension plan.
The CARES act was passed by the government last year to help Americans deal with the economic fallout from COVIDD-19. Stimulus checks highlighted the bill, but it had a few other provisions that attempted to help people financially if they experienced job loss or were diagnosed with the coronavirus.
One of the provisions in the CARES act allowed for penalty free "early" distributions from retirement accounts.
Typically, money cannot be taken from pretax reiemtmeent account before age 59 1/2. If an early withdrawal is made, a 10% penalty is assessed on your withdrawal amount and is due at tax time.
This provision created so people could access their retirement accounts without paying early withdrawal penalties. If you were economically impacted by COVID in 2020, you could withdraw up to $100,000 from retirement account without paying the 10% penalty.
However, you're still required to pay tax on the distribution -- this didn't change. This tax shows up on the previously mentioned 1099-R. In many cases, receiving a 1099-R came as a surprise and caught a lot of people off guard.
Money taken from a pretax retirement account is always taxable income, regardless of your age or employment status.
Luckily, there are some additional features of this CARES act provision that can help lessen the burden of the tax hit.
Let's take a look at some examples of how to mitigate the tax burden of COVID-19 retirement account withdrawals.
The taxable income on the 1099-R can be spread over the 3 tax years from 2020-2022. For example, if your taxable income (amount in box 2 of the 1099-R) is $30,000, you can claim all income in 2020, or elect to spread 1/3 of the taxable income amount into the next 3 tax years. Effectively in this scenario, the taxpayer would pay tax on a $10,000 distribution for 3 years rather than tax on $30,000 in 2020.
A taxpayer can add back all of the distributed amount to a qualified retirement plan before filing their 2020 taxes. This would effectively cancel out their distribution and no tax would be owed.
The taxpayer can add back a portion of their distribtuionn. This can be done now or in 2021, or 2022. Any amount of money paid back into a qualified retirement account will decrease the total amount of tax owed.
If you pay the tax now but add the money back into your retirement account later, you can file an amended return for previous tax years and receive a refund check for your overpayment.
What is the strategy then, you ask?
That depends on your particular situation and financial plan. Since the retirement distributions are added to your taxable income, one strategy is to properly time when you're actually "recognizing" the income to your tax return. If you're expecting relatively high or low income in one of the tax years from 2020-2022, it makes sense to recognize most of the retirement distribution tax in years when your AGI is lowest. Alternatively, payback most or all of your retirement account distribution when your AGI is the highest.
Like I said before, if you overpay in previous years you can always go back and amend the prior return to get a refund.
Even as I type this, trying to keep it as simple as possible, I understand it may still be a bit confusing. I assure you though it's not as complicated as it sounds -- especially if you're working with someone who know whats they're doing.
I hope this was helpful. As always, please don't hesitate to contact us or another qualified Enrolled Agent if you need help.