COVID-19: Two New Retirement Account Strategies You Need to Know
The newly enacted CARES Act made several important retirement account tax law changes that apply to tax year 2020 only.
You have a limited window to use the new strategies, so you need to consider the options today.
First, we’ll tell you two ways you can undo a required minimum distribution (RMD) that you took in 2020 before Congress waived your requirement.
Second, we’ll tell you how you can potentially qualify for a particular tax benefit from a Roth IRA conversion in 2020.
Strategy 1: Undo Your 2020 RMD
Once you reach the magic age of 70 1/2 (before January 1, 2020) or 72 (after December 31, 2019), you must start taking annual RMDs from your traditional IRAs.
Here’s the good news: due to the economic crisis, Congress waived all RMDs you’d otherwise have to take for tax year 2020.
But here is the bad news: the RMD law change does not have a repayment provision. So, if you took out your RMD before Congress granted you mercy, then you are generally out of luck.
A 60-day indirect IRA rollover
A coronavirus-related distribution
Indirect Rollover Loophole
Here are the two most important rules you need to know for indirect rollovers:
Rule 1. You take money out of a traditional IRA and return it to the same IRA or another traditional IRA within 60 days and owe no taxes or penalties.
Rule 2. You can do only one indirect IRA rollover per year.
See Retirement Plan and IRA Rollover Advice for more information.
Sixty days expanded. At this moment, you could have more than 60 days to do your rollover. The IRS postponed your rollover deadline if the last day of your 60-day period fell on or after April 1, 2020, and before July 15, 2020. If you are in this situation, you now have until July 15, 2020, to replace the funds for a successful indirect rollover.
Example. Paul took out his $3,000 RMD for the tax year 2020 on February 12, 2020. Usually, Paul would have until April 12, 2020, to complete a 60-day indirect rollover, but the IRS postponed the deadline, and Paul now has until July 15, 2020, to complete the indirect rollover.
Coronavirus-Related Distribution Loophole
If your distribution qualifies as a coronavirus-related distribution, then you can pay it back to your retirement account as a trustee-to-trustee rollover.
By doing this, you avoid income tax on your distribution, and the cash is back in your retirement account.
A coronavirus-related distribution is one made to you on or after January 1, 2020, and before December 31, 2020, if you meet one of the following three tests:
You are diagnosed with COVID-19 using a test approved by the Centers for Disease Control and Prevention (CDC).
Your spouse or dependent is diagnosed with COVID-19 using a CDC-approved test.
You are experiencing adverse financial consequences as a result of being quarantined, being furloughed or laid off or having work hours reduced due to such virus or disease, being unable to work due to lack of child care due to such virus or disease, closing or reducing hours of a business owned or operated by you due to such virus or disease, or other factors as determined by the secretary of the Treasury (or the secretary’s delegate).
If you meet one of the requirements, you can repay your 2020 RMD within three years of the distribution date. But to avoid complications, you’ll want to replace the RMD before December 31, 2020.
If you want more information on coronavirus-related distributions, we cover all the rules you need to know in COVID-19: CARES Act Allows $100,000 Tax-Free IRA Grab and Repay.
Example. Sarah took her $5,000 RMD from her traditional IRA on January 10, 2020. Sarah’s husband received a COVID-19 diagnosis with a CDC-approved test. Sarah can replace the $5,000 on or before December 31, 2020, and pay no income tax on the RMD.
Strategy 2: Roth IRA Conversion
Tax year 2020 might be an ideal time for a Roth IRA conversion because stock market values have decreased this year.
We already listed a Roth IRA conversion as a valuable tax strategy to consider in 2019 Last-Minute Year-End Medical and Retirement Deductions.
But now you can get an even better tax benefit than usual if your Roth IRA conversion also qualifies as a coronavirus-related distribution, because you can spread up to $100,000 of the income from the Roth IRA conversion equally over tax years 2020, 2021, and 2022.
The ability to spread the conversion income over three years might allow you to pay a lower tax rate than you would pay on a lump-sum inclusion.
The following special rules apply to Roth IRA conversions treated as coronavirus-related distributions:
You increase the income in any tax year by any Roth IRA distributions allocable to the Roth IRA conversion amount.
If you die before including the entire conversion amount in income, then you have to include all the remaining amounts in your taxable income in the tax year you die.
Planning alert! If you have a business loss in tax year 2020 that could offset the conversion income, you may want to recognize all the income in 2020 to make the conversion partially or fully tax-free. We discuss this strategy in Five Strategies for Your Business Loss after Tax Reform.
You also have this planning option with a coronavirus-related distribution: you can elect out of the three-year income spread and claim all the income in tax year 2020.
Example. Stuart’s restaurant is subject to a partial shutdown due to COVID-19. He takes $30,000 out of his traditional IRA on March 5, 2020, and contributes it to a Roth IRA in November 2020. Stuart has two options:
he can elect out of the coronavirus-related distribution and include the entire $30,000 as taxable income in tax year 2020, or
he can treat the distribution as a coronavirus-related distribution and recognize $10,000 of income in each of tax years 2020, 2021, and 2022.
Stuart might take option 1 if he has an overall net loss in tax year 2020 or if the entire $30,000 is subject to a lower tax rate in 2020 than in 2021 and 2022.
Stuart might take option 2 if he believes his marginal tax rates will be the same or lower in 2021 and 2022 when compared to including the entire $30,000 as income in tax year 2020.
Takeaways
Due to the COVID-19 pandemic, Congress made changes to the tax law related to retirement account distributions. The changes open up new, time-limited ways for you to save tax dollars.
Congress waived all 2020 RMDs. But if you took your RMD before Congress made this change, you have two ways you can undo it:
Use the expanded 60-day indirect rollover, if you qualify.
Treat the RMD as a coronavirus-related distribution, and recontribute the funds, if you qualify.
Because of the financial downturn, this may be the year to convert your traditional IRA to a Roth IRA. If you are eligible for a coronavirus-related distribution (highly likely), you can convert up to $100,000 of your traditional IRA to a Roth and take advantage of the three-year spread of the taxable income.
If you have a tax year 2020 loss, you may want to include the conversion income in tax year 2020 so that the loss fully or partially offsets your tax-free Roth IRA conversion.
But if your distribution qualifies for one of the two loopholes below, you can put the cash back with no tax consequence to you: