One Major Red Flag To Watch Out for if You Take Cash Out of Your IRA Under the CARES Act


Heads up — while you are now allowed to take up to $100,000 out of your IRA and pay it back within three years with no tax hit, doing so may have some hidden consequences that you likely have overlooked initially.

The Internal Revenue Code calls these tax-favored withdrawals “coronavirus-related distributions,” which will be referred to as “CVDs.” It’s important to note that while not all IRA owners will be eligible for the CVD privilege, many probably will and you could be among them.

If you qualify for this CVD privilege, you will be allowed to take one or more CVDs in 2020 up to a combined limit of $100,000. You can then re-contribute (repay) any CVD amount to an IRA that has been set up in your name within the three-year window. You will be expected to treat each CVD and the related contribution as a federal-income-tax-free IRA rollover transaction.

There are no restrictions on how you can use CVD funds. If you’re cash-strapped, you can use the money to pay bills and recontribute later (within the three-year window) when your financial situation improves. You can even help out your adult kids now and recontribute later, making CVDs an extremely useful cash-flow management tool in these troubled times.

Don’t get too excited — there are some interim tax consequences if you decide to take advantage of this opportunity.

While you can re-contribute a CVD within the three-year window and pay the typical federal-income-tax-free IRA rollover transaction, there are some interim federal tax consequences to take care of before you arrive at that favorable tax-free outcome.

Unfortunately, the interim tax consequences can diminish the cash-flow advantage of the CVD deal and require filing amended returns to gain federal-income-tax-free treatment. The interim tax consequences were recently clarified when the Congressional Joint Committee on Taxation (JCT) released its explanation of the tax provisions in the CARES Act. 

How the interim tax consequences work

If you take several CVDs (up to the $100,000 combined limit), the interim tax consequences apply separately to each CVD. But let’s keep things as simple as possible to make the following examples easier to understand.

Example 1: You recontribute early

If you have the necessary cash, you can recontribute the CVD amount in the next two years. For instance, if you re-contribute the entire $100,000 in 2022, there won’t be any interim tax hit for that year. File amended returns for 2020 and 2021 to get back the interim tax hits for those years. Once again, the CVD is federal-income-tax-free at the end of the day, but it is not free of caveats. 

Example 2: You recontribute in 2023

Let’s assume you are eligible for the CVD privilege and make the decisions to take $100,000 CVD from your traditional IRA sometime this year. The $100,000 would be fully taxable under the regular federal income tax rules for traditional IRA withdrawals. (If you’ve made nondeductible traditional IRA contributions over the years, the withdrawal would not be 100% taxable, but we’re keeping things simple here.)

The JCT report explains that the usual way to line up federal-income-tax-free treatment for your CVD involves spreading the $100,000 of taxable income that you would report under the regular tax rules equally over 2020, 2021, and 2022. So, you would report $33,333.33 on your 2020 Form 1040. The same goes for 2021 and 2022.

After re-contributing the entire $100,000 sometime in 2023, before the three-year window closes, you would file amended returns for 2020, 2021, and 2022 and get back the interim federal income tax hits for those years. At the end of the day, the CVD is federal-income-tax-free, as advertised, but the road to get there is long and bumpy.

Example 3: You report all CVD income on your 2020 return

You also have the option of reporting the entire $100,000 of CVD income on your 2020 Form 1040. If you re-contribute the $100,000 within the three-year window, you file an amended return for 2020 to get back the interim tax hit. You generally must file an amended 2020 return within three years from the date you filed your original 2020 Form 1040.

No matter what path you take, your results will likely vary from the examples above.

To put it simply, the interim tax consequences of taking this cash out of your IRA under the CARES act will have at least a few inconvenient consequences. Beyond that, some consequences may be unfavorable enough to skip the process altogether. If you are trying to decide whether or not to take advantage of the CVD opportunity, consider contacting an associate at Milikowsky Tax Law for assistance. 

As you can see, the interim tax consequences are at least inconvenient. And they can be downright unfavorable — because they can reduce the cash-flow management advantage of the CVD deal.