COVID-19 Compliance Corner: How Are Coronavirus-Related Distributions Taxed?

The tax rules that usually apply to retirement plan distributions do not apply to coronavirus-related distributions (CRDs). Instead, there are special rules for distributions made to “qualified individuals” affected by the coronavirus—the definition of “qualified individuals” was discussed in a previous column. While there are unanswered questions about how coronavirus-related distributions will be reported and taxed, the IRS in recent FAQs has given preliminary guidance as well as indicated its intention to interpret the new rules in the same manner as the rules applicable to similar special Hurricane Katrina distributions under a law known as the Katrina Emergency Tax Relief Act of 2005 (KETRA).

Total distributions from all plans and individual retirement accounts (IRAs) this year that are eligible for special tax treatment as coronavirus-related distributions may not exceed $100,000 per qualified individual. Eligible distributions can include distributions made in 2020 before the Coronavirus Aid, Relief and Economic Security (CARES) Act was passed and “regular” plan distributions such as hardship distributions, termination distributions and distributions at age 59 1/2.

What are the usual rules?

Distributions are generally taxed in the year they are received unless they are rolled over within 60 days to an individual retirement account (IRA), tax qualified plan or other eligible retirement plan. An additional 10% early distribution penalty applies to many distributions made prior to age 59 1/2, including hardship distributions. Mandatory 20% withholding is taken out of any taxable distribution eligible for rollover unless the distribution is paid directly to the trustee or custodian of an eligible retirement plan. Distributions not eligible for rollover, such as annuity payments, are taxable when paid and subject to 10% withholding unless the recipient elects different withholding.

What is different about coronavirus-related distributions?

Qualified individuals who receive coronavirus-related distributions:

• Are not subject to 20% withholding, even though their distributions have special recontribution (rollover) rights;
• May spread out their tax liability by taking their distribution into income ratably over three years beginning with the year in which the distribution was received;
• Will have 10% withholding taken out unless they elect otherwise;
• Are not subject to the 10% early distribution penalty;
• Have a right to recontribute all or part of their distributions to an eligible retirement plan that accepts rollovers, including an IRA, within three years of the date of the distribution. The general limit of one rollover a year does not apply; and
• Can reduce the taxable portion of a distribution to the extent that it is recontributed to an eligible retirement plan or IRA.

All plans are not required to accept rollovers and therefore to accept recontributions. However, a coronavirus-related distribution need not be recontributed to the plan that made the distribution. Participants may have the option of recontributing distributions to a new employer’s plan or to an IRA.

Amended returns may be required to claim special tax treatment

If a distribution is repaid before the tax return for the year of distribution has been filed, it is not taxable income, although the plan sponsor will still need to report the distribution on Form 1099-R. If taxes are being paid over three years, and repayment is made after the return for the year of distribution has been filed, amended returns for prior years may be required to claim the tax benefit. Guidance issued for similar distributions after Hurricane Katrina indicates that if the recontribution exceeds the amount of the distribution taken into income that year, the recontribution may be carried back or carried forward. For example, a qualified individual who received a distribution of $75,000 in 2020 and elected to pay the income tax over three years might repay $30,000 in 2021. The $25,000 portion of the distribution that would have been taken into income in 2021 would then be reduced to zero and the excess $5,000 could be carried back or carried forward.

What are the obligations of plan sponsors and administrators?

Plan sponsors are free to determine whether to permit special coronavirus-related distributions from their plans and whether their plans accept rollovers. Presumably, plans that do not accept rollovers until new employees complete the service requirement for eligibility will be able to enforce that condition.  

Plan sponsors that do permit CRDs need to limit total coronavirus-related distributions from all their plans and the plans of their controlled group members to $100,000. However, a plan sponsor is not required to investigate whether the participant received additional distributions from outside sources. Plan sponsors and administrators are permitted to rely on participant certifications as to eligibility.

Coronavirus-related distributions will be reported on Form 1099-R, but we do not know whether a special code will be required for CRDs. If, as many anticipate, a special code is not required, plan sponsors and administrators will not have to determine whether all distributions made during the tax year qualify for special treatment.  

The onus here is on participants, who will be responsible for determining how to report distributions and recontributions on their tax returns. We expect they will use a form similar to current IRS Form 8915. If they received distributions from more than one employer or from employer plans and an IRA, and, for that reason, the total received exceeds $100,000, regardless of how the distributions have been reported, the total amount of distributions that could be treated by the qualified individual as coronavirus-related distributions could not exceed $100,000.

The IRS indicates that it intends to issue more guidance on reporting. Plan sponsors and administrators should be on the alert for this new guidance, and they should also be aware that state tax treatment of coronavirus distributions may be different from the federal tax treatment.

Carol Buckmann is a co-founding partner of Cohen & Buckmann P.C. As a highly regarded employee benefits and ERISA [Employee Retirement Income Security Act] attorney, Buckmann deals with the foremost issues in ERISA, including pension plan compliance, fiduciary responsibilities and investment fund formation.

She has 40 years of practice in this area of the law and a depth of experience on complex pension law and fiduciary problems. She regularly shares her thoughts on new developments in the benefits industry on Insights, Cohen & Buckmann’s blog, and writes and speaks on ERISA topics. Buckmann has been recognized by Martindale-Hubbell as an AV Pre-eminent Rated Lawyer, was selected for inclusion in the Best Lawyers in America and was named one of the Super Lawyers in Employee Benefits.