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November 11, 2022 at 01:07 PM
What You Need to Know
- The CARES Act allowed plan participants to take up to $100,000 in distributions from an employer-sponsored retirement plan without paying a 10% penalty.
- The three-year repayment period for many of these taxpayers will expire in just a few short months.
- Plan participants who have yet to account for any of the tax liability related to those distributions may wish to consider filing amended returns to avoid penalties.
The 2020 CARES Act provided relief for 401(k) borrowers that made the 401(k) “loan” option much more attractive. While much of the relief was limited to early distributions taken out in 2020, many taxpayers are still grappling with decisions regarding those loans. That’s because the repayment and taxation options were also changed to encompass a three-year repayment or taxability period.
As we approach 2023, that three-year grace period is about to expire for many taxpayers who opted to take advantage of the early distribution option. Those clients who haven’t been paying attention should take note and evaluate their individual situations to make sure they’re reaping all of the tax benefits afforded to plan loans and early distributions during the height of the COVID-19 pandemic.
2020 CARES Act Relief: The Basics
The CARES Act allowed plan participants to take up to $100,000 in distributions from an employer-sponsored retirement plan (such as a 401(k), 403(b) or defined benefit plan) or an IRA without being subject to the 10% early distribution penalty. Unless the participant elected otherwise, inclusion of the distribution in income was spread over three years, beginning with the tax year of distribution.
While taxpayers should have included at least one-third of the distribution in income for 2020, 2021 and 2022, they also had the option of including the full distribution in income during 2020.
The plan loan rules were also expanded to increase the available loan limit from $50,000 to $100,000 during the 180-day period beginning March 27, 2020.
Importantly, the CARES Act increased the appeal by allowing employees to repay eligible distributions during the three-year tax period beginning with the tax year of distribution (whether in a lump sum or installments over time).
While these relief provisions were not expanded for COVID-19-related reasons, they often apply in situations involving severe natural disasters.
Tax Moves and Year-End Considerations
Taking an early distribution or plan loan may seem like an attractive option. Tapping a 401(k) does not require a credit check and won’t have an adverse impact on the borrower’s credit score. Unfortunately, there are also unintended side effects. Now, as many taxpayers consider whether to repay their COVID-19-related distributions, it’s important to evaluate the impact carefully.
