CARES Act Distribution: Why Did I Take One?

What is a CARES ACT Distribution?   

If someone has been negatively impacted by COVID-19, they are eligible to withdraw up to $100,000 from an IRA or 401k without triggering the 10% penalty.   The income on this distribution can be spread over three years (ie:  realize $33,334, $33,333, and $33,333 on 2020, 2021, and 2022 tax returns) and also may be repaid up until December 31st, 2022.   The guidance is written as “up to”, allowing a distribution of less than $100,000.  You also have the option of realizing more than 1/3rd of the income in the first year.

What counts as negatively impacted by COVID-19?

Directly from the IRS’s Frequently Asked Questions, the following are considered events that make someone a qualified individual:  

• You are diagnosed with the virus SARS-CoV-2 or with coronavirus disease 2019 (COVID-19) by a test approved by the Centers for Disease Control and Prevention;
• Your spouse or dependent is diagnosed with SARS-CoV-2 or with COVID-19 by a test approved by the Centers for Disease Control and Prevention;
• You experience adverse financial consequences as a result of being quarantined, being furloughed or laid off, or having work hours reduced due to SARS-CoV-2 or COVID-19;
• You experience adverse financial consequences as a result of being unable to work due to lack of child care due to SARS-CoV-2 or COVID-19; or
• You experience adverse financial consequences as a result of closing or reducing hours of a business that you own or operate due to SARS-CoV-2 or COVID-19.

The third and fourth qualifications are probably the most open to interpretation under this guidance and will likely face scrutiny as individuals report these distributions.  Be prepared to respond with a nice letter and supporting documentation if the IRS sends you an inquiry.

How Did I Qualify For a CARES Act Distribution?

I wrote about my layoff from a friend’s company I was helping.  The company revolved around public gatherings and had to move quickly in March when faced with government mandated shutdowns.  Since they were paying me on a W-2 basis and not through a 1099, I received a termination letter citing COVID-19 as the reason for my termination.  I feel pretty confident if I get an inquiry letter from the IRS questioning the distribution, I can respond with a kind letter back and include a copy of the termination notice referencing COVID-19 and it’ll put their concerns to rest.  My thought is the IRS will probably be examining the distributions closely because of the uniqueness of waiving the 10% penalty.  $10,000 is a lot of money and this is an unprecedented opportunity.  Individuals may want to consult with a tax professional if their qualification is less straightforward.  

How Did I Decide To Take The Distribution?

The CARES Act distribution rules came to my attention a few months after it was passed.  I had already completed one small Roth IRA conversion for 2020 and planned on doing another one before year-end.   The Roth IRA conversions have the advantage of going into another qualified account and growing tax deferred, but do not give access to the funds in five years.  I debated for a couple months between doing another conversion or a CARES Act distribution, but ultimately settled on the CARES Act distribution.   Why?

1. Replenishing the Taxable Account.  I held most of our individual stock investments in our taxable account and some of those were in industries that haven’t rebounded like the entire market (Cruise Lines, Banks, Restaurants, Industrials).   We were up for the year on some of our accounts and down on others, but the account that was down the most was our taxable account.  

2. Future Home Purchase:  Most of our assets are in sheltered accounts and getting a mortgage as an early retiree can be a challenge.  I no longer have a W-2 income and only have interest, dividends, IRA distributions, and self employment income.  The IRA distributions and self employment income generally require two years on tax returns before being considered as recurring income for the purposes of a mortgage.   After this distribution we would be more comfortable buying a property outright.

3. Flexibility:  Funds outside of retirement accounts are just more flexible.  I can get to them whenever I want and invest in anything I’d want to.  There are some alternative investments like debt or syndicated real estate that have additional cost to use the IRA.  This also allowed me to move part of our bond allocation outside of retirement accounts and that now gives me comfort if we have another serious market crash.  Having multiple years of accessible living expenses in a stable investment provides peace of mind

What About Taxes?

One of the issues I had to come to terms with in doing the CARES Act distribution is this was *not* the optimal tax decision.  It would be more optimal to roll these funds into a Roth IRA and only withdraw the contributions in the future.  Holding bonds in our taxable account also isn’t the most optimal decision.  I had to balance that against the benefits above.  One reality I’m facing is if there are modest market returns, it is unlikely I would be able to get all of our IRA funds out without going over the 12% federal tax rate.  Our tendency to earn a little bit of money plus a small pension that’ll kick in at 55 if they don’t make me a fair lump sum offer beforehand.    

The good thing is we saved anywhere from 24% to 39% on taxes when the funds went into the IRAs, as it stands today the worst case scenario is paying 29% to get funds out (22% Federal, 7% State).   This is about a wash compared to paying the taxes when it went in, plus I have accrued earnings over the years that were not exposed to taxes.  Either way, I will be paying some level of taxes eventually when the money comes out.

Speaking of tax planning, it is always just an educated guess as to what tax rates/policy will be in the future.  We are in the midst of an election campaign with the existing administration running a three trillion dollar deficit for the current fiscal year and attempting to further reduce taxes while the opposing candidate is promising three trillion more in taxes in exchange for eleven trillion in additional spending.  I’m not the most politically inclined person, but I think the country has to figure out how to stop growing the country’s total debt to gross domestic product.   The followers of Modern Monetary Theory might disagree with me, but I don’t believe there’s a free lunch and eventually these debts are curbed through taxes or inflation.  Personally I expect both to happen and getting some funds out of my IRA is a nice hedge against higher rates in the future.  

Only time will tell if this is a smart decision, but this opportunity presented itself and I decided to utilize it.   

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