The Coronavirus Aid, Relief, and Economic Security (CARES) Act provides for expanded distribution options and favorable tax treatment for up to $100,000 of coronavirus-related distributions (CRDs) from certain employer-sponsored retirement plans (e.g., 401(k) and 403(b) plans) and IRAs.
The IRS recently posted a set of Q&As that address CRDs and the special CARES Act loan rules. Published prior to the issuance of the IRS guidance, our previous alert focused on CRDs as a new type of in-service distribution option. This alert maintains the same focus.
The IRS is formulating additional guidance on CRDs and anticipates releasing that guidance in the near future. The IRS indicates the additional guidance will apply the principles of Notice 2005-92, which was published in connection with similar distribution rules promulgated under the Katrina Emergency Tax Relief Act of 2005.
Are CRDs a mandatory type of in-service distribution option for 401(k), 403(b), and governmental 457(b) plans?
No. The guidance confirms employers are free to choose whether, and to what extent, to amend a plan to provide CRDs. For example, an employer may establish a limit on the availability of in-service CRDs that is lower than the $100,000 maximum.
Can money purchase and defined benefit pension plans be amended to offer CRDs as a new type of in-service distribution option?
No. The IRS confirms the CARES Act does not expand the existing in-service distribution rules that apply to pension plans (i.e., money purchase pension plans, cash balance plans, and traditional defined benefit pension plans).
Under current rules, distributions from a pension plan may not be made prior to a participant’s severance from employment unless the participant has attained the earlier of the plan’s normal retirement age (which may not be earlier than age 62 for most plans) or, if a plan so provides, age 59 1/2. The same restrictions apply to that portion of a participant’s account under a 401(k) or profit-sharing plan that is attributable to amounts directly transferred from a pension plan (e.g., through a plan merger) as long as the portion of the participant’s account attributable to the transferred amounts is separately accounted for by the plan. If the assets are not separately tracked, the distribution restrictions apply to all plan accounts.
Notwithstanding these distribution restrictions, a pension plan distribution (e.g., a lump sum payment) can qualify as a CRD.
Is an employee eligible for a CRD if the employee experiences adverse financial consequences based on a change in a spouse’s employment status?
Currently, the answer is “no,” although it is possible that could change. While an employee may be eligible for a CRD if the employee’s spouse or dependent is diagnosed with COVID-19, an employee’s eligibility based on adverse financial consequences due to COVID-19 cannot be based on a change in the employment status of the employee’s spouse. As it currently stands, an employee’s adverse financial consequences must result from the employee’s own change in employment status. The Q&As state the IRS is contemplating an expansion of the list of factors taken into account for this purpose.
May a plan administrator rely on an employee’s certification of eligibility for a CRD if the plan administrator has actual knowledge that the employee does not meet the requirements?
No. The IRS guidance states a plan administrator may rely on an individual’s certification of eligibility for a CRD unless the administrator knows the individual is not a qualified individual. In other words, a plan may not make a CRD if the administrator knows an employee, spouse, or dependent has not been diagnosed with COVID-19 or that the employee has not, in fact, experienced adverse financial consequences resulting from work-related events caused by COVID-19.
What are the tax consequences associated with CRDs?
- An employee must include the taxable portion of a CRD in income ratably over the three-year period commencing with the year of distribution unless the employee elects to include the distribution in income in the year the distribution is received. CRDs are not subject to the 10-percent additional tax that applies to early distributions from qualified retirement plans.
- Example: Employee Smith receives a CRD of $21,000 in 2020, all of which is taxable. Unless Smith chooses to include the distribution in income in 2020, Smith’s 2020, 2021, and 2022 federal income tax return would report one-third of the distribution ($7,000) as taxable income for each year.
- Under the Q&A guidance, Smith’s distribution would be reported on Form 1099-R even if Smith repays the distribution in 2020. The IRS expects to provide additional information on tax reporting for CRDs later this year.
- An employee has the right to repay some or all of a CRD and avoid taxation of some or all of the amount initially distributed. If an employee repays some or all of a CRD to an eligible retirement plan within three years of the date of distribution, the amount repaid reduces the taxable income attributable to the CRD for the year in which the CRD is taxed, even if the repayment is made in a subsequent tax year.
- An eligible retirement plan includes an IRA, a qualified plan (e.g., 401(k) plan) a 403(b) plan, and a governmental 457(b) plan. The IRS guidance notes qualified retirement plans generally are not required to accept rollover contributions; accordingly, the guidance concludes that if an employer’s plan does not accept rollover contributions, it would not need to amend its plan to accept a CRD repayment.
- The following examples are based on the IRS Q&As and Notice 2005-92.
- Example – Entire CRD is taxed in the year of receipt and is repaid, in part, in a subsequent tax year.
- Employee Smith receives a $21,000 CRD from a 401(k) plan in 2020 and receives no other CRD from any eligible plan (including an IRA) in 2020. Smith elects to report the entire taxable portion as income for 2020, the year of receipt. If Notice 2005-92 principles are followed, Smith would make this election using Form 8915 or a tax form similar to Form 8915. Assume Smith repays $14,000 to the 401(k) plan in 2021 after filing a 2020 income tax return. If Notice 2005-92 principles are adopted for CRDs, Smith will be required to file an amended return for 2020 (including a revised Form 8915) to report the amount of the repayment and reduce Smith’s gross income for 2020 by $14,000.
- Example – CRD is taxed ratably over a three-year period and is repaid within the three-year period.
- Same facts as the prior example, except Smith does not elect to include the entire distribution in income in 2020. As a result, Smith’s CRD is taxed ratably over a three-year period—$7,000 for each of 2020, 2021, and 2022. Assume Smith repays the full amount—$21,000—to an eligible retirement plan in 2022. The guidance states that Smith may file amended federal income tax returns for 2020 and 2021 to claim a refund of the tax attributable to the amount of the distribution that was included in income for those years and will not be required to include any amount in income in 2022.
The Q&A guidance refers to additional examples in Notice 2005-92. These examples are found in sections 4.D, 4.E., and 4.F. of Notice 2005-92.
If you have any questions regarding the content of this alert, please contact Art Marrapese, Employee Benefits Practice Area chair, at amarrapese@barclaydamon.com or another member of the firm’s Employee Benefits Practice Area.