In an earlier column, I was rather enthusiastic about the provision in the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) that allows an eligible IRA owner to withdraw up to $100,000 in 2020 and pay the money back within three years with no federal income tax hit. The Internal Revenue Code calls these tax-favored withdrawals coronavirus-related distributions. I call them CVDs. For the basics on how CVDs work, see this previous Tax Guy. As explained in the earlier column, not all IRA owners will be eligible for the CVD privilege. But many probably will, and you could be among them.
If you are among them, you can take one or more CVDs in 2020 up to a combined limit of $100,000. You can then recontribute (repay) any CVD amount to any IRA that’s set up in your name within the three-year window. You treat each CVD and the related recontribution as a federal-income-tax-free IRA rollover transaction.
There are no restrictions on how you can use CVD funds. If you’re cash-strapped, you can use the money to pay bills and recontribute later (within the three-year window) when your financial situation improves. You can help out your adult kids now and recontribute later. Whatever. So, a CVD can be a useful cash-flow management tool in these troubled times.
So far, so good.
The catch: not-so-great interim tax consequences
It’s true that if you recontribute a CVD within the three-year window, the ultimate result is the same as a federal-income-tax-free IRA rollover transaction. However, there are interim federal tax consequences before you arrive at that favorable tax-free outcome.
Unfortunately, the interim tax consequences can diminish the cash-flow advantage of the CVD deal and require filing amended returns to gain federal-income-tax-free treatment. The interim tax consequences were recently clarified when the Congressional Joint Committee on Taxation (JCT) released its explanation of the tax provisions in the CARES Act. So, we now have the full CVD picture, and we will now examine it closely. Here goes.
How the interim tax consequences work
If you take several CVDs (up to the $100,000 combined limit), the interim tax consequences apply separately to each CVD. But let’s keep things as simple as possible to make the following examples easier to understand.
Example 1: You recontribute in 2023
You are eligible for the CVD privilege. You take one $100,000 CVD from your traditional IRA sometime this year. The $100,000 would be fully taxable under the regular federal income tax rules for traditional IRA withdrawals. (If you’ve made non-deductible traditional IRA contributions over the years, the withdrawal would not be 100% taxable, but we’re keeping things simple here.)
The JCT report explains that the usual way to line up federal-income-tax-free treatment for your CVD involves spreading the $100,000 of taxable income that you would report under the regular tax rules equally over 2020, 2021, and 2022. So, you would report $33,333.33 on your 2020 Form 1040. Ditto for 2021 and 2022.
After recontributing the entire $100,000 sometime in 2023, before the three-year window closes, you would file amended returns for 2020, 2021, and 2022 and get back the interim federal income tax hits for those years. At the end of the day, the CVD is federal-income-tax-free, as advertised. But it’s a chore to get there.
Example 2: You recontribute early
If you have the necessary cash, you don’t have to wait until sometime in 2023 to recontribute the CVD amount. For instance, if you recontribute the entire $100,000 in 2022, there won’t be any interim tax hit for that year. File amended returns for 2020 and 2021 to get back the interim tax hits for those years. Once again, the CVD is federal-income-tax-free at the end of the day. Once again, it’s a chore to get there.
Example 3: You report all CVD income on your 2020 return
You also have the option of reporting the entire $100,000 of CVD income on your 2020 Form 1040. If you recontribute the $100,000 within the three-year window, you file an amended return for 2020 to get back the interim tax hit. You generally must file an amended 2020 return within three years from the date you filed your original 2020 Form 1040.
Warning: We don’t know what tax rates will be after this year
As the preceding examples illustrate, you can potentially have interim tax hits in 2021 and 2022, even if you recontribute the entire CVD amount within the three-year window. Depending on future events, political developments, and the ultimate cost to the federal government of the COVID-19 crisis, there’s a distinct possibility that tax rates could be higher in 2021 and 2022. Maybe much higher. If that happens, the interim tax hits in 2021 and 2022 would be that much higher. That would diminish the cash-flow management advantage of the CVD deal. As long as you recontribute within the three-year window, you’ll eventually get the tax hits back, but keep this warning in mind.
Your results may vary
As you can see, the interim tax consequences are at least inconvenient. And they can be downright unfavorable — because they can reduce the cash-flow management advantage of the CVD deal. That said, CVDs can still work well in specific circumstances. For instance:
* If your 2020 taxable income turns out to be much lower than usual due to COVID-19 fallout, you might have only a modest federal income tax hit from the CVD income reported on this year’s Form 1040. You’ll have extra cash in hand, and you’ll eventually get back any interim tax hit — as long as you recontribute within the three-year window.
* If you have negative 2020 taxable income because of business losses due to COVID-19 fallout, you might benefit from reporting all the CVD income on your 2020 Form 1040. If you can shelter most or all that income with business losses, great. You’ll have extra cash in hand, and you’ll owe little or no federal income tax on your 2020 Form 1040. If you have sufficient cash later on, you can recontribute all or part of the CVD amount, within the three-year window. You’ll get back some or all of any tax hit from 2020, and you get the recontributed amount back into tax-favored IRA status.
* If you recontribute the CVD amount sooner than required, you’ll have extra cash in hand for now, and you can mitigate the unfavorable interim tax consequences — as illustrated in Example 2.
What if I don’t recontribute within the three-year window?
That’s another option. You’ll have taxable income from the CVD amount that you don’t recontribute, but you won’t owe the 10% early withdrawal penalty tax that generally applies to IRA withdrawals taken before age 59½.
As explained in the Examples, you can spread the taxable income from the CVD equally over three years, starting with 2020.
You also have the option of reporting all the taxable income from the CVD on your 2020 return, if that makes sense in your situation.
Remember: If it later turns out that you have enough cash to recontribute within the three-year window, you can always decide to recontribute and recover any related federal income tax hit.
Bottom line: CVDs are beneficial in specific circumstances
The CVD privilege can be a potentially helpful tax-favored cash-flow management tool for eligible IRA owners. You can get needed cash into your hands right now. You can then recontribute the CVD amount within the three-year window that will close sometime in 2023 — depending on the date you take the CVD — to ultimately avoid any federal income tax hit. You can recontribute anytime within that three-year window.
Unfortunately, the interim tax consequences can be a significant negative factor. That said, I think the CVD deal is a viable strategy when:
1. You have a rather desperate for immediate cash, and
2. You are confident that you can recontribute within the three-year window (the sooner the better),
3. You can shelter most or all of the CVD income with 2020 business losses, which can make recontributing an option rather than a tax-avoidance necessity.
The last word
You don’t need to make any decisions that will affect how your CVD will be taxed until October 15 of next year — if you extend the filing deadline for your 2020 Form 1040. So, you have plenty of time to consult your tax pro about how to optimize the CVD experience. I encourage you to do that.
Note:Many thanks to Ed Slott (a fellow CPA) for lending his expertise to this column. In Tax Guy’s opinion, Ed is our nation’s No. 1 guru on the subject of IRAs. Check out his website at www.irahelp.com.