Important Deadline Approaching for Clients Who Tapped 401(k)s During Pandemic

Ensure these clients are reaping the tax benefits afforded to them under the CARES Act.

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.

Most obviously, the loan or distribution will reduce the borrower’s 401(k) account balance. Less money in the account means that the taxpayer’s investment returns could suffer significantly. While today’s rocky market may motivate many taxpayers to choose not to recontribute 401(k) funds, that could mean that the taxpayer might miss out on significant appreciation if and when the markets rebound.

Taxpayers who elect to forgo the three-year repayment option should also be reminded that, while the distributions may not be subject to the 10% early withdrawal penalty, they are subject to ordinary income tax.

Those taxpayers could elect to spread the tax liability over a three-year period. Plan participants who have yet to account for any of that tax liability may wish to consider filing amended returns to avoid penalties.

Typically, 401(k) loans must be repaid within five years (with interest) to avoid penalties. Plan participants who took qualified distributions during the initial year of the COVID era, fortunately, have the option of repaying those funds without interest and without generating any additional tax liability.

The three-year repayment period for many of these taxpayers will expire in just a few short months.

To date, it seems that repayments should be reported in the same manner as any other qualified disaster distributions. That means the repayments should be reported on Forms 5498, IRA Contribution Information, in Box 14a using Code DD (disaster distribution). The borrower must also self-certify to the IRS that they were eligible to make the repayment.

Some taxpayers have already paid a portion of the taxes due on the distribution and may choose to repay the funds at a later date, within the three-year period. Those taxpayers should file an amended return to recover the taxes that have already been paid on amounts that were repaid.

Conclusion

For clients who took advantage of the CARES Act relief during 2020, now is the time to take action. It’s important to carefully evaluate their individual circumstances to ensure they aren’t missing out on the tax benefits afforded to COVID-related distributions.

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