The 2021 tax-filing season is getting off to a delayed start. The IRS recently announced it would first begin accepting tax returns on Feb. 12, whereas the agency normally starts taking returns at the end of January.
If you're expecting a refund on this year's tax return, you may be eager to start gathering your paperwork and getting your taxes together. But if you took a CARES Act withdrawal from your retirement plan last year, you'll also have some big decisions to make -- whether to put that money back or not, and how to spread out your tax liability if you don't intend to replace those funds.
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Don't get burned on your taxes
Normally, withdrawing funds from an IRA or 401(k) plan prior to age 59 1/2 results in a 10% early withdrawal penalty, plus taxes on that distribution assuming it came from a non-Roth account. Those taxes aren't a penalty -- they would apply after age 59 1/2 as well.
The CARES Act, however, allowed savers impacted by the coronavirus pandemic to withdraw up to $100,000 from their IRAs or 401(k)s penalty-free. It also allows those who went that route to put that money back within three years and avoid the tax liability it would otherwise create. And if your financial situation has improved since taking that distribution, it could pay to exercise that option and return that money to your retirement plan so it can not only get reinvested and grow, but also, so you can avoid what could be a whopping tax liability in the near term.
Normally, you're required to pay taxes on a retirement plan withdrawal for the tax year you take it in. The CARES Act, however, allows those who took distributions to spread their tax liability out over three years. If you're unable to return your withdrawal to your retirement savings, you'll need to think about how and when you're going to pay those taxes. You could, for example, pay taxes on one-third of your distribution this year. Or, you could pay taxes on your entire distribution if you can swing that bill.
Of course, if you don't pay any taxes on your distribution this year, you'll owe that money later, so if you took a sizable withdrawal, it could pay to consult a tax professional and see what makes the most sense for you. Claiming your full distribution on your 2020 tax return could make sense if your income took a substantial hit and you've been pushed into a much lower tax bracket than you normally fall into. On the other hand, you'll need to weigh the tax benefits of doing so with your personal cash flow situation.
Now you may be thinking of deferring your tax liability this year in case you're able to pay back your CARES Act withdrawal later on. That's not a terrible move, but it could backfire -- if you don't end up managing to return that withdrawal, you could have a major tax headache later on.
A mixed bag
On the one hand, the option to withdraw funds penalty-free from an IRA or 401(k) was a lifeline for workers who lost their jobs or saw their income take a significant hit during the pandemic. But those who took advantage of that provision may now be in a tough spot from a tax perspective. If you removed funds from your retirement plan and are in a position to replenish them, that's generally your best bet. If you can't manage that, you'll need to figure out how to tackle your tax bill as strategically as possible.
