Dire financial straits faced by countless Americans, as a result of the adverse effects of the coronavirus disease 2019 (COVID-19), have forced many to take premature distributions from their retirement savings accounts. These premature distributions have resulted in erosions of paths to financially secured retirement for many. But, Steven Mnuchin, as United States Secretary of the Treasury, could make temporary changes that would help to ease the potential financial burden caused by these distributions.
Money saved in tax-deferred retirement accounts- such as traditional and Roth IRAs, 401(k)s, and 403(b)s, are usually intended to help finance the account owner’s retirement years. Earnings accrue on these amounts on a tax-deferred basis, and any pre-tax and tax-deferred amounts are taxable only when distributed to the account owner- or beneficiary if distributions occur after the owner’s death. For Roth IRAs, earnings eventually become tax-free when the owner is eligible to take a qualified distribution. An example of a qualified distribution from a Roth IRA is one that occurs at least 5-years after one funds one’s first Roth IRA and one is at least age 59 ½ when the distribution occurs.
Distributions made before the account owner reaches age 59 ½ are considered premature and could be subject to a 10% additional tax (early distribution penalty).
A distribution- including one that is premature- can be restored to a retirement account, by rolling over the amount within 60-days of receipt, thus preserving the tax-deferred status and avoiding taxation. But a rollover is allowed, only if certain requirements have been satisfied.
For instance, if one takes a distribution from an IRA and rolls over the amount within 60-days of receipt, the amount would be excludible from income, providing the amount is eligible for rollover. One is permitted to take a distribution from an IRA and roll over the amount to the same or another IRA only once during a 12-month period. A rollover that breaks this rule is an example of an amount that is ‘ineligible’ for rollover. This one per 12-month-period limitation, does not apply to rollovers that involve employer sponsored retirement plans, such as 401(k)s and 403(b)s.
Mr. Mnuchin has already made some changes that could help Americans effectively maneuver the COVID-19 pandemic- financially speaking. This includes extending the deadline, by which individuals are required to file their tax returns and make regular IRA contributions, from tax-filing due date- which is April 15 for most Americans- to July 15. See IR-2020-58, March 21, 2020.
But there is much more that can and should be done. To that end, I hope that as Mr. Mnuchin continues to look for more ways to help affected Americans he considers the following; for those who have no choice but to take distributions their retirement savings, due to COVID-19 related financial hardships.
1. Waive the 10% early distribution penalty for early/premature distributions made during and as a result of the COVID-19 pandemic: Under IRC § 72(t), a distribution made from a tax-deferred retirement account- such as an IRA, 401(k) or 403(b) is subject to a 10% additional tax (early distribution penalty), if it is made before the retirement account owner reaches age 59 ½. This is increased to 25%, if the distribution is made from a SIMPLE IRA, during the 2-year period which begins on the first day a SIMPLE IRA contribution is made to the individual’s SIMPLE IRA.
While there are some exceptions to this penalty, distributions due to financial hardships is not on the list of exceptions.
Mr. Mnuchin can help by adding a temporary exception for COVID-19 related distributions.
2. Extend the 60-day Rollover Deadline for distributions made due to COVID-19: A distribution from a tax-deferred retirement account is includible in income, and no longer eligible for tax-deferred growth, unless the amount is properly rolled over. This means that income tax would be due on any pre-tax amount, plus the aforementioned 10% early distribution penalty, unless the amount is properly rolled over.
One of the requirements that makes a rollover ‘proper’ is that the amount is rolled over within 60-days of the participant receiving the distribution amount. Many retirement account owners who take distributions due to COVID-19 related financial hardship will not be able to meet this 60-day deadline for obvious reasons, and would therefore need a waiver for this deadline.
Mr. Mnuchin can help by using his authority, under IRC § 408(d)(3)(I), to extend the 60-day deadline for COVID-19 related distributions. Ideally, this extension should be at least 24 months (instead of 60 days), possibly longer, allowing affected taxpayers sufficient time to get back on their financial feet.
3. Allow the rollover of hardship distributions from 401(k) type plans: An employer sponsored retirement plan, such as 401(k) plans and 403(b) plans, may allow an eligible participant to make a hardship withdrawal to cover “an immediate and heavy financial need”.
While this is a helpful provision for participants with such a need, those who take advantage of it must pay income tax and the aforementioned 10% early distribution penalty on any pre-tax amounts included in hardship distributions. This applies even for those who could later afford to roll over the amounts, because under IRC § 402(c)(4), hardship distributions are not eligible for rollover.
As a result, if one is forced to make a hardship withdrawal due to COVID-19, one would not have the opportunity to replenish one’s retirement account for those amounts, even if one is able to come up with the funds later.
Mr. Mnuchin can help by permitting the rollover of hardship distributions that are made as a result of COVID-19 related financial hardships.
4. Permit the recharacterization of Roth IRA conversions done in 2019 and 2020: An amount converted to a Roth IRA is includable in income, for the year in which the conversion is done. Roth conversions done before 2018 were permitted to be recharacterized by the Roth IRA owner’s tax filing due date plus extensions for the year in which the conversion was done.
A recharacterization would result in the amount being treated as if it was never converted, for tax purposes; allowing for those who find themselves with converted amounts that has since lost market value to reverse their conversions. This would be an ideal solution for those who performed Roth conversions in 2019 and 2020, and the conversions have since lost significant market value as a result of the COVID-19 bear market.
Unfortunately, the Tax Cuts and Jobs Act (Pub. L. No. 115-97) prohibits the recharacterization of Roth conversions done after 2017. As a result, most taxpayers who performed Roth conversions from employer sponsored retirement plans and non-Roth IRAs in 2019 and 2020 will be paying income taxes on retirement savings that they no longer have (and did not benefit from), due to COVID-19 related market losses. For example, an individual who converted $100,000 to a Roth IRA would be required to pay income tax on the full $100,000, even if the market value has since fallen to $50,000.
Mr. Mnuchin can help by providing a one-time waiver of the prohibition of recharacterization of Roth conversions, for conversions done in 2019 and 2020.
This is Only A Start
These changes could help many affected Americans get back on the path to a financially secured retirement. There are many other changes that Mr. Mnuchin can make. But these would be an excellent list with which to start.