Repaying a COVID-Related Distribution

Do you remember a tax break in 2020 that allowed you to take (up to) $100,000 from your IRA or your employer retirement plan? These were called “coronavirus-related distributions,” or CRDs in the lingo. In and of itself, the provision was not remarkable. What was remarkable is that one was allowed three years to return some, all, or none of the money to the IRA or employer plan, as one wished.

I was thinking recently that I do not remember seeing 2021 individual returns where someone returned the money.

Granted, we have a flotilla of returns on extension here at Galactic Command. I may yet see this beast in its natural state.

Let’s go over how this provision works.

To make it easy, let’s say that you took $100,000 from your 401(k) in 2020 for qualifying COVID-related reasons.

You had an immediate binary decision:

·      Report the entire $100,000 as income in 2020 and pay the taxes immediately.

·      Spread the reporting of the $100 grand over three years – 2020, 2021 and 2022 - and pay taxes over three years.

There was no early-distribution penalty on this distribution, which was good.

You might wonder how paying the tax immediately could be preferable to paying over three years. It could happen. How? Say that you had a business and it got decimated by COVID lockdowns. Your 2020 income might be very low – heck, you might even have an overall tax loss. If that were the case, reporting the income and paying the tax in 2020 might make sense, especially if you expected your subsequent years’ income to return to normal levels.

What was a COVID-related reason for a distribution?

The easy ones are:

·      You, a spouse or dependent were diagnosed (and possibly quarantined) with COVID;

·      You had childcare issues because of COVID;

·      You were furloughed, laid-off or had work hours reduced because of COVID.

Makes sense. There is one more:

·      You experienced other “adverse financial consequences” because of COVID.

That last one has an open-gate feel to me. I’ll give you an example:

·      You own rental cabins in Aspen. No one was renting your cabins in 2020. Did you experience “adverse financial consequences” triggering this tax provision?

You have – should you choose to do so – three years to put the money back. The three-year period starts with the date of distribution, so it does not automatically mean (in fact, it is unlikely to be) December 31^st three years later.

The money doesn’t have to return to the same IRA or employer plan. Any qualifying IRA or employer plan will work. Makes sense, as there is a more-than-incidental chance that someone no longer works for the same employer.

 Let’s say that you decide to return $50 grand of the $100 grand.

The tax reporting depends on how you reported the $100 grand in 2020.

Remember that there were two ways to go:

·      Report all of it in 2020

This is easy.

You reported $100 grand in 2020.

When you return $50 grand you … amend 2020 and reduce income by $50 grand.

What if you return $50 grand over two payments – one in 2021 and again in 2022?

Easy: you amend 2020 for the 2021 and amend 2020 again for the 2022.

Question: can you keep amending like that – that is, amending an amended?

Answer: you bet.

·       Report the $100 grand over three years.

This is not so easy.

The reporting depends on how much of the $100 grand you have left to report.

Let’s say that you are in the second year of the three-year spread and repay $30,000 to your IRA or employer plan.

The test here is: did you repay the includable amount (or less) for that year?

If yes, just subtract the repayment from the includable amount and report the difference on that year’s return.

In our example, the math would be $33,333 - 30,000 = $3,333. You would report $3,333 for the second year of the spread.

If no, then it gets ugly.

Let’s revise our example to say that you repaid $40,000 rather than $30,000.

First step: You would offset the current-year includable amount entirely. There is nothing to report the second year, and you still have $6,667 ($40,000 – 33,333) remaining.

You have a decision.

You have a year left on the three-year spread. You could elect to carryforward the $6,667 to that year. You would report $26,666 ($33,333 – 6,667) in income for that third and final year.

You could alternatively choose to amend a prior year for the $6,667. For example, you already reported $33,333 in 2020, so you could amend 2020, reduce income by $6,666 and get an immediate tax refund.

Which is better? Neither is inherently better, at least to my thinking. It depends on your situation.

There is a specific tax form to use with spreads and repayments of CRDs. I will spare us the details for this discussion.

There you have it: the ropes to repaying a coronavirus-related distribution (CRD).

If you reflect, do you see the complexity Congress added to the tax Code? Multiply this provision by however many times Congress alters the Code every year, and you can see how we have gotten to the point where an average person is probably unable to prepare his/her own tax return.

 

No Required Minimum Distributions For 2020

There is a tax deadline coming up. It may matter to those who are taking required minimum distributions (MRDs) from your IRAs and certain employer-based plans.

You may recall that there is a trigger concerning retirement plans when one reaches age 72.

COMMENT: The trigger used to be age 70 ½ for tax years before 2020.

The trigger is – with some exception for employer-based plans – that one has to start withdrawing from his/her retirement account. There are even IRS-provided tables, into which one can insert one’s age and obtain a factor to calculate a required minimum distribution.

COMMENT: There are severe penalties for not withdrawing a minimum distribution. Fortunately, the IRS is fairly lenient in allowing one to “catch-up” and avoid those penalties. At 50% of the required distribution, the MRD penalty rate is one of the most severe in the tax Code.

Let’s say that you are in the age range for MRDs. You have, in fact, been taking monthly MRDs this far into 2020.

There has been a law change: you can take 2020 distributions if you wish, but distributions are not mandatory or otherwise required. That is, there are no MRDs for 2020. This means that you can take less than the otherwise-table-calculated amount (including none, if you wish) and not taunt that 50% penalty.

Why the change in tax law?

The change is related to the severe economic contractions emanating from COVID and its associated lockdowns and stay-at-home restrictions. Congress realized that there was little financial sense in forcing one to sell stocks and securities into a bear market to raise the cash necessary to pay oneself MRDs.

Hot on the heels of the change is the fact that different people take MRDs at different times. Some people take the distribution early in the year, others late, and yet others take distributions monthly or quarterly. There is no wrong answer; it just depends on one’s cash flow needs.

Let’s take the example we started with: monthly distributions.

Well, it’s fine and dandy that I do not have to take any more distributions, but what about the amount I took in January -before the law change? And February – before …., well, you get the point.

You can put the money back into the IRA or retirement account.

Think of it as a mulligan.

But you have to do this by a certain date: August 31, 2020.

You have approximately another month to get it done.

Here are some questions you may have:

(1)  Does this change apply to 401(k)s, 403(b)s, 457(b)s?

Answer: Yes.

(2)  How about inherited accounts?

Answer: Yes. You have to put it back in the same (that is, the inherited) account, of course.

(3)  What if I was having taxes withheld?

Answer: You are going to have reach into your pocketbook temporarily. Say that you took a $25,000 distribution with 20% federal withholding. You never spent any of it, so you have $20,000 sitting in your bank account. If you want to unwind the entire transaction, you are going to have to take $5,000 from somewhere, add it to the $20,000 you already have and put $25,000 back into your IRA or retirement account.

You may wonder what happened to the $5 grand that was withheld. It will be refunded to you – when you file your 2020 tax return.

(4)  Continuing with Example (3): what if I don’t have the $5 grand?

Answer: Then put back the $20,000 you do have. It’s not 100%, but you put back most of it. You will have that gigantic withholding when you finally file your 2020 taxes.

(5)  What if I turned 70 ½ last year (2019) and HAVE TO take a MRD in 2020?

Answer: The answer may surprise you. The downside to waiting is that you would (normally) have to take a distribution for 2019 (you turned 70 ½, after all) and another for 2020 itself. This means that you are taking two MRDs in one tax year. Under the new 2020 tax law, you do not have to take EITHER (2019 or 2020) distribution. Your first distribution would be in 2021, and you would have had no distributions for 2019 or 2020.

(6)  Does this change apply to pensions?

Answer: No. Pensions are “defined benefit” plans, whereas IRAs, 401(k)s and so on are “defined contribution” plans. The change is only for defined contribution plans.

(7)  Does this change apply to Roths?

Answer: Roths do not have minimum required distributions, so this law change means bupkis to them.

(8)  What if I went the other way: I withdrew from my traditional IRA and would like to put it back as a Roth?

Answer: Normally one cannot do this, as MRDs do not qualify for a Roth conversion. With no MRDs for 2020, however, you have a one-time opportunity to flip some of your traditional IRA into a Roth. Remember that you will have to pay tax on this, though.  

(9)  How does this law change interact with the qualified charitable distribution rules?

Answer: A qualified charitable distribution (QCD) is when you have your IRA custodian issue a check directly to a charity. You do not get a deduction for the contribution, but the upside is that you do not have to report the distribution as income. If you do not itemize deductions, this technique is – by far – the most tax-efficient way to go. The QCD rules are independent of the MRD 2020 rule change. If you want to donate via charitable distributions in 2020, then go for it!

If you are already into your MRD for 2020 and do not need the money – some or all of it – remember that you have approximately another month to put it back.

New Life Expectancy Tables For Your Retirement Account

On November 7, 2019 the IRS issued Proposed Regulations revising life expectancy tables used to calculate minimum required distributions from retirement plans, such as IRAs.

That strikes me as a good thing. The tables have not been revised since 2002.

There are three tables that one might use, depending upon one’s situation. Let’s go over them:

The Uniform Lifetime Table

This is the old reliable and the one most of us are likely to use.

 Joint Life and Last Survivor Expectancy Table

This is more specialized. This table is for a married couple where the age difference between the spouses is greater than 10 years.

The Single Life Expectancy Table

Do not be confused: this table has nothing to do with someone being single. This is the table for inherited retirement accounts.

Let’s take a look at a five-year period for the Uniform Lifetime Table:

Age	Old	New	Difference
71	26.5	28.2	1.7
72	25.6	27.3	1.7
73	24.7	26.4	1.7
74	23.8	25.5	1.7
75	22.9	24.6	1.7

If you had a million dollars in the account, the difference in your required minimum distribution at age 71 would be $2,275.

It is not overwhelming, but let’s remember that the difference is for every remaining year of one’s life.

As an aside, I recently came across an interesting statistic. Did you know that 4 out of 5 Americans receiving retirement distributions are taking more than the minimum amount? For those – the vast majority of recipients – this revision to the life expectancy tables will have no impact.

Let’s spend a moment talking about the third table - the Single Life Expectancy Table. You may know this topic as a “stretch” IRA.

A stretch IRA is not a unique or different kind of IRA. All it means is that the owner died, and the account has passed to a beneficiary. Since minimum distributions are based on life expectancy, this raises an interesting question: whose life expectancy?

COMMENT: There is a difference on whether a spouse or a non-spouse inherits. It also matters whether the decedent reached age 70 ½ or not. It is a thicket of rules and exceptions. For the following discussion, let us presume a non-spouse inherits and the decedent was over age 70 ½.

An easy way to solve this issue would be to continue the same life expectancy table as the original owner of the account. The problem here is that – if the beneficiary is young enough – one would run out of table.

So let’s reset the table. We will use the beneficiary’s life expectancy.

And there you have the Single Life Expectancy Table.

As well as the opportunity for a stretch. How? By using someone much younger than the deceased. Grandkids, for example.

Say that a 35-year old inherits an account. What is the difference between the old and new life expectancy tables?

                                Old             48.5

                                New            50.5

Hey, it’s better than nothing and – again – it repeats every year.

There is an odd thing about using this table, if you have ever worked with a stretch IRA. For a regular IRA – e.g., you taking distributions from your own IRA – you look at the table to get a factor for your age in the distribution year. You then divide that factor into the December 31 IRA balance for the year preceding the distribution year to arrive at the required minimum amount.

Point is: you look at the table every year.

The stretch does not do that.

You look at the table one time. Say you inherit at age 34.  Your required minimum distribution begins the following year (I am making an assumption here, but let’s roll with it), when you are age 35. The factor is 48.5. When you are age 36, you subtract one from the factor (48.5 – 1.0 = 47.5) and use that new number for purposes of the calculation. The following year you again subtract one (47.5 – 1.0 = 46.5), and so on.

Under the Proposed Regulation you are to refer to the (new) Single Life Expectancy Table for that first year, take the new factor and then subtract as many “ones” as necessary to get to the beneficiary’s current age. It is confusing, methinks.

There are public comment procedures for Proposed Regulations, so there is a possibility the IRS will change something before the Regulations go final. Final will be year 2021.

So for 2020 we will use the existing tables, and for 2021 we will be using the new tables.

Depression And Disability

I am reading a Tax Court case where the taxpayer represented himself. This is referred to as “pro se.” Technically, it does not mean that you cannot have an attorney or advisor with you; it rather means that the attorney or advisor is not admitted to practice before the Tax Court. If I was your CPA, for example, I would field the questions-and-answers on your behalf while you sat there silent and forlorn. You would still be considered to be “pro se,” as I do not practice before the Court. Had I practiced in the D.C. area or with the national tax office of a large firm, I might have been more interested in pursuing admission to practice.

The taxpayer’s name is Walter Kowsh, and he had an incredible string of misfortune. Walter lived in New York. His wife died at age 53, leaving him with two teenage children and an elderly parent.

Then he lost several friends on the 9/11 attacks on the World Trade Center. Some of those friends had gone to his wife’s funeral.

By 2002 he could longer work because of depression and anxiety attacks.

He started taking prescriptions, including Wellbutrin and Paxil.

His depression became debilitating.

He started collecting on his private disability insurance.

He did not however apply for Social Security disability. Too bad, as there is a case (Dwyer) that accepts social security as proof of disability.

He took an early distribution from his 401(k) or IRA in 2003. He did not however file a tax return for 2003.

So the IRS tentatively prepared one for him.

After a string of IRS notices, he finally prepared and filed his 2003 return.

The IRS next wanted penalties for late filing as well as the 10% penalty on the early distribution.

Walter needed an out from both penalties. Is there way to do it?

Yep.

Disability would do it. Disability is an exception to the 10% penalty and is also reasonable cause to abate a late filing penalty.

Walter argued that he was disabled.

Question is: did Walter’s depression rise to the level of a disability?

Incredible story, said the IRS. Get us a doctor’s letter, and let’s wrap this up.

Walter could not – or would not - get a doctor’s letter. His own doctor refused to provide one.

This was a bad start.

How about a prescription history from the pharmacy? asked the IRS. They might be able to print out your history for the whole year.

Nope, said Walter.

I am already collecting disability, continued Walter. What part of “disability” do you not understand?

Walter could really have used a tax advisor at this point.

You see, collecting disability from an insurance company lends strong credibility to Walter’s claim, but disability is a medical diagnosis. The insurance reinforces the diagnosis but is not a substitute for it.

Rest assured the Court was curious why Walter’s doctor would not provide a letter, or why he refused to have another doctor provide one…

… despite numerous requests from respondent.”

Respondent means the IRS.

And I am curious myself.

I do not doubt that he was depressed. I also do not doubt that he considered himself disabled. What I don’t understand is the big pushback on what appears to be a reasonable request.

It is not personal, Walter. Stop taking it that way.

Walter lost.

You see the downside to a true pro se.

I would have been screaming at Walter for sabotaging his own case. He would have gotten that doctor’s letter or I would have fired him.

But Walter made the tax literature for the point that collecting private disability insurance, by itself and without further substantiation, does not prove disability for purposes of the tax Code.

Tax geeks will remember Walter for decades.

Can Creditors Reach The Retirement Account Of A Divorced Spouse?

Let’s say that you divorce. Let say that retirement savings are unequal between you and your ex-spouse. As part of the settlement you receive a portion of your spouse’s 401(k) under a “QDRO” order.

COMMENT: A QDRO is a way to get around the rule prohibiting alienation or assignment of benefits under a qualified retirement plan. I generally think of QDROs as arising from divorce, but they could also go to a child or other dependent of the plan participant.

Your QDRO has (almost) the same restrictions as any other retirement savings. As far as you or I are concerned, it IS a retirement account.

You file for bankruptcy.

Can your creditors reach the QDRO?

Sometimes I scratch my head over bankruptcy decisions. The reason is that bankruptcy – while having tax consequences – is its own area of law. If the law part pulls a bit more weight than the tax part, then the tax consequence may be nonintuitive.

Let’s segue to an inherited IRA for a moment. Someone passes away and his/her IRA goes to you. What happens to it in your bankruptcy?

The Supreme Court addressed this in Clark, where the Court had to address the definition of “retirement funds” otherwise protected from creditors in bankruptcy.

The Court said there were three critical differences between a plain-old IRA and an inherited IRA:

(1)  The holder of an inherited IRA can never add to the account.

(2)  The holder of an inherited IRA must draw money virtually immediately. There is no waiting until one reaches or nears retirement.

(3)  The holder of an inherited IRA can drain the account at any time – and without a penalty.

The Court observed that:

Nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after bankruptcy proceedings are complete.”

The Court continued that – to qualify under bankruptcy – it is not sufficient that monies be inside an IRA. Those monies must also rise to the level of “retirement funds,” and – since the inheritor could empty the account at a moment’s notice - the Court was simply not seeing that with inherited IRAs.

I get it.

Let’s switch out the inherited IRA and substitute a QDRO. With a QDRO, the alternate payee steps into the shoes of the plan participant.

The Eighth Circuit steps in and applies the 3-factor test of Clark to the QDRO. Let’s walk through it:

(1)  The alternate payee cannot add to a QDRO.

(2)  The alternate payee does not have to start immediate withdrawals – unless of required age.

(3)  The alternate payee cannot – unless of required age - immediately empty the account and buy that vacation home or sports car.

By my account, the QDRO fails the first test but passes the next two. Since there are three tests and the QDRO passes two, I expect the QDRO to be “retirement funds” as bankruptcy law uses the term.

And I would be wrong.

The Eighth Circuit notes that tests 2 and 3 do not apply to a QDRO. The Court then concludes that the QDRO has only one test, and the QDRO fails that.

The Eighth Circuit explains that Clark:

… clearly suggests that the exemption is limited to individuals who create and contribute funds into the retirement account.”

It is not clear to me, but there you have it – at least if you live in the Eighth Circuit.

No bankruptcy protection for you.

Our case this time for the home gamers was In re Lerbakken.

The Abbott Laboratories 401(k)

Something caught my eye recently about student loans. A 401(k) is involved, so there is a tax angle.

Abbott Laboratories is using their “Freedom 2 Save” program to:

… enable full-time and part-time employees who qualify for the company's 401(k) – and who are also contributing 2 percent of their eligible pay toward student loans – to receive an amount equivalent to the company's traditional 5 percent "match" deposited into their 401(k) plans. Program recipients will receive the match without requiring any 401(k) contribution of their own.”

Abbott will put money into an employee’s 401(k), even if the employee is not himself/herself contributing.

As I understand it, the easiest way to substantiate that one’s student loan is 2% or more of one’s eligible pay is to allow Abbott to withhold and remit the monthly loan amount. For that modest disclosure of personal information, one receives a 5% employer “match” contribution.

I get it. It can be difficult to simultaneously service one’s student loan and save for retirement.

Let’s take this moment to discuss the three main ways to fund a 401(k) account.

(1)  What you contribute. Let’s say that you set aside 6% of your pay.

(2)  What your employer is committed to contributing. In this example, say that the company matches the first 4% and then ½ of the next 2%. This is called the “match,” and in this example it would be 5%.

(3)  A discretionary company contribution. Perhaps your employer had an excellent year and wants to throw a few extra dollars into the kitty. Do not be skeptical: I have seen it happen. Not with my own 401(k), mind you (I am a career CPA, and CPA firms are notorious), but by a client. 

Abbott is not the first, by the way. Prudential Retirement did something similar in 2016.

The reason we are talking about this is that the IRS recently blessed one of these plans in a Private Letter Ruling. A PLR is an IRS opinion requested by, and issued to, a specific taxpayer. One generally has to write a check (the amount varies depending upon the issue), but in return one receives some assurance from the IRS on how a transaction is going to work-out taxwise. Depending upon, a PLR is virtually required tax procedure. Consider certain corporate mergers or reorganizations. There may be billions of dollars and millions of shareholders involved. One gets a PLR – period – as the downside might be career-ending.

Tax and retirement pros were (and are) concerned how plans like Abbott’s will pass the “contingent benefits” prohibition. Under this rule, a company cannot make other employee benefits – say health insurance – contingent on an employee making elective deferrals into the company’s 401(k) plan.

The IRS decided that the prohibition did not apply as the employees were not contributing to the 401(k) plan. The employer was. The employees were just paying their student loans.

By the way, Abbott Laboratories has subsequently confirmed that it was they who requested and received the PLR.

Technically, a PLR is issued to a specific taxpayer and this one is good only for Abbott Laboratories. Not surprisingly there are already calls to codify this tax result. Once in the Code or Regulations, the result would be standardized and a conservative employer would not feel compelled to obtain its own PLR.

I doubt you and I will see this in our 401(k)s.  This strikes me as a “big company” thing, and a big company with a lot of younger employees to boot.

Great recruitment feature, though.

Tax Return That Surprised An Accountant

Let’s do something a little different this time.

I want you to see numbers the way a tax CPA does.

Let’s say that you are semi-retired and you bring me your following tax information:

                    W-2                                         24,000

                    Interest income                            600

                    Qualified dividend income      40,000

                    Long-term capital gains          10,000

                    IRA                                         24,000

Looks to me like you have income of $98,600.

How about deductions?

                    Real estate taxes                    10,000

                    Mortgage interest                      5,000

                    Donations                                26,000

I am seeing $41,000, not including your exemptions.

You did some quick calculations and figure that your federal taxes will be about $6,500. You want to do some tax planning anyway, so you set up an appointment. What can you do to reduce your tax? 

What do I see here?

I’ll give you a hint.

Long-term capital gains have a neat tax trick: the capital gains tax rate is 0% as long as your ordinary income tax rate is 15% or lower. This does not mean that you cannot have a tax, mind you. To the extent that you have taxable income in excess of those capital gains, you will have tax.

Let’s walk though this word salad.

Income $98,600 – deductions $41,000 – exemptions $8,100 = $49,500 taxable income.

You have capital gains of $10,000.

Question: will you have to pay tax on the difference – the $39,500?

Answer: qualified dividends also have a neat tax trick: for this purpose, they are taxed similarly to long-term capital gains.

NOTE: Think of qualified dividends as dividends from a U.S. company or a foreign company that trades on an U.S. exchange and you are on the right path.

You have capital gains and qualified dividends totaling $50,000.

Your taxable income is $49,500.

All of your taxable income is qualified dividends and capital gains, and you never left the 15% tax bracket.

What is your tax?

Zero.

How is that for tax planning, huh?

From a tax perspective, you hit a home run.

Let me change two of the numbers so we can better understand this qualified dividend/capital gain/taxable income/15% tax bracket thing.

                    W-2                                         36,000

                    Qualified dividends                 28,000

As you probably can guess, I left your taxable income untouched at $49,500, but I changed its composition.

You now have capital gains and qualified dividends of $38,000. Your taxable income is $49,500, meaning that you have “other” income in there. You are going to have to pay tax on that “other” income, as it does not have that qualified dividend/capital gain trick.

The tax will be $1,153.

You still did great. It is just that no tax beats some tax any day of the week.

It is something to consider when you think about retirement planning. We are used to thinking about 401(k)s, deductible IRAs, Roth IRAs, social security and so on, but let’s not leave out qualified dividends and capital gains. Granted, capital gains are unpredictable and not a good fit for reliable income, but dividend-paying stocks might work for you. When was the last time Proctor & Gamble missed a dividend payment, for example?

OK, I admit: if you leave the 15% tax bracket the above technique fizzles. That however would take approximately $76,000 taxable income for marrieds filing jointly. Congrats if that is you.

BTW I saw scenario one during tax season (I tweaked the numbers somewhat for discussion, of course). The accountant was perplexed and asked me to look at the return with him. The zero tax threw him.

Now he knows the dividend/capital gain thing, and so do you.