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The Coronavirus Aid, Relief, and Economic Stimulus (CARES) Act, enacted in March, contained a number of provisions designed to provide relief to cash-strapped taxpayers, including retirees. Key breaks included reduced penalties for taking early IRA distributions, waiver of required minimum distributions (RMDs) and the option to spread taxes on retirement plan distributions over three years.
After carefully reading the provisions some taxpayers and tax advisors developed strategies to multiply the benefits of the CARES Act. The question taxpayers have to ask is whether these strategies are too good to be true and will later come back to bite them once the IRS begins reviewing them
Two key provisions of the CARES Act seem to make these aggressive strategies possible.
One provision waives RMDs for 2020. This is especially important to someone who is subject to RMDs and wants to convert all or part of a traditional IRA to a Roth IRA.
In a normal year when the RMD rules apply, a taxpayer has to take the RMD for the year before converting any of the traditional IRA. First the RMD must be taken out of the IRA and included in gross income. Only after that can the remaining portion of the traditional IRA be converted to a Roth IRA. The amount of the traditional IRA that is converted to a Roth IRA also is included in gross income and taxed as ordinary income.
Many IRA owners don’t want to convert part of their IRAs if they first have to take an RMD and pay taxes on it. They believe the tax burden for the year is too high to justify the benefits of the conversion.
But in 2020, IRA owners who normally are subject to RMDs have a unique opportunity. They don’t have to take an RMD. They can convert whatever is in the traditional IRA and pay taxes only on the converted amount. Some want to convert to a Roth IRA an amount that ordinary would be their RMD for the year. Others are taking the opportunity to convert more of the traditional IRA.
Another provision of the CARES Act allows someone who was affected by Covid-19 or the coronavirus pandemic to take an IRA or 401(k) distribution of up to $100,000 and pay the income taxes on that distribution over three years. Instead of including the entire distribution in gross income for 2020, the distribution can be included in gross income pro rata for 2020, 2021 and 2022.
To be considered affected by Covid-19, an individual, spouse or dependent must have been diagnosed with the disease. An individual also qualifies if he or she experienced an adverse financial consequence from being quarantined, was laid off or had work hours reduced. An individual also qualifies for the break by suffering a financial hardship due to the lack of child care or because a business owned or operated by the individual was closed or had to reduce hours because of the coronavirus pandemic.
Here’s one strategy that some people developed from these rules.
Suppose an IRA owner who normally is subject to the RMD rules qualifies as someone affected by the coronavirus pandemic. Let’s say the individual is a business owner who had to close the business temporarily under government orders.
The individual doesn’t have to take an RMD for 2020. That’s true whether or not the individual was affected by Covid-19.
The individual can convert all or part of a traditional IRA into a Roth IRA. The conversion is treated for tax purposes as a distribution and included in the individual’s gross income. Or the individual can take a distribution of cash from the IRA and within 60 days roll it over to a Roth IRA. That counts as a conversion to a Roth IRA.
In either case, because the individual was affected by Covid-19, the taxes on the converted amount up to $100,000 can be paid over three years instead of in the year of the distribution. The conversion is much more financially appealing when the taxes can be spread over three years instead of lumped into one year.
The strategy seems to fit the letter of the CARES Act. But it clearly is something Congress didn’t intend. The intent of the provisions in the law was to help individuals who are financially strapped because of the pandemic. Someone who can take a distribution of up to $100,000 from a traditional IRA and roll it over to a Roth IRA is likely not someone in financial distress.
The IRS could rule at some point that the three-year tax payment election doesn’t apply to a distribution that is rolled over in the same year or a short time after the distribution. It also could rule that a direct rollover from a traditional IRA to a Roth IRA doesn’t count as a distribution for purposes of the three-year tax payment election. It’s not clear that a court would uphold either ruling. But a taxpayer would have to incur the time and cost to litigate against the IRS and take the risk of losing.
Another strategy applies to someone who is eligible to make a tax deductible contribution to a traditional IRA and has been affected by Covid-19. The person could make a contribution to the IRA. Then, the person could take a distribution from the IRA.
Under the CARES Act rules, the taxes on the distribution can be spread over three years. Also, if the taxpayer is under age 59½ another provision of the CARES Act waives the 10% early distribution penalty in 2020 for someone affected by Covid-19. The deduction for the IRA contribution can be taken in 2020. The result is the taxpayer receives a tax deduction for making an IRA contribution and has the same amount of cash because the contribution was distributed from the IRA. The deduction for the contribution is taken in 2020, but the taxes on the distribution are spread over three years.
This is another strategy that seems to follow the letter of the tax law but isn’t what Congress intended. The IRS could issue a ruling concluding that the strategy doesn’t work because of the step-transaction doctrine. Under this doctrine a series of related actions is collapsed into one transaction to prevent artificial tax results. The taxpayer wouldn’t be considered to have made a contribution to the IRA, because the same amount was distributed soon after the contribution.
While these transactions appear to comply with the terms of the tax law, they aren’t what Congress intended. There are arguments the IRS can use to challenge them in audits and court cases.