I took out a COVID-19-related 401(k) withdrawal in 2020 that will default this year (2022) due to a job-change and continued economic hardship. Will I have the option to pay the taxes over a three-year period? Or should I plan my withholdings to account for the full disbursement to be taxed all at once on next year's taxes?
The CARES act does not apply in 2022. However, the SECURE act means that if you default on a 401(k) loan during 2022, you have until the tax deadline (April 15, 2023) to make a contribution back to the same 401(k), or to a private IRA and have it considered a non-taxable rollover. For example, if the defaulted loan balance is $25,000, and you manage to make a $10,000 rollover contribution before April 15, then you would only have a deemed distribution of $15,000. The deemed distribution is subject to regular income tax plus a 10% penalty.
What this means is that you should carefully consider your investment and retirement options if you get a new job before April 15, 2023. Suppose you have the option of contributing to a 401(k) and your new job gives you sufficient financial resources to do that. If you make contributions to your new 401(k), you will get the tax deduction but you will pay income tax and the penalty on the default loan balance. However, if you took the money that you would have contributed to the 401(k) and put it in an IRA instead as a rollover contribution, you would not get a tax deduction, but you would avoid the income tax and the penalty on the deemed distribution. (If you do this, make sure you tell the IRA custodian that this is a rollover contribution due to a defaulted 401(k) and not a regular contribution.)
As the April 15 deadline approaches, you might also consider the idea of taking a short term bank loan to make the rollover contribution, because the interest on the loan would probably be a lot less than the tax and penalty on the deemed distribution, especially if your financial situation in 2023 would allow you to repay the loan easily.
So as far as your tax and withholding situation for 2022 are concerned, if you don’t think that you will be able to make a rollover contribution by April 15, 2023, you should plan to pay income tax and the penalty on the defaulted loan balance. However, if you can make rollover contributions to an IRA, that could significantly reduce the tax you owe.
Also note that the 401(k) administrator will probably not accept a rollover repayment if it is after 60 days. That’s OK because you can make the rollover contribution to a private IRA instead.
If you took out the withdraw in 2020, but it will not default until 2022, it would be deemed a distribution in 2022. To be a a qualified Covid Withdraw, the distribution would have had to happen in 2020. Since it did not, you would be taxed all at once on your 2022 tax return as the covid withdrawal rules have not yet been extended to any years other than 2020.
The CARES act does not apply in 2022. However, the SECURE act means that if you default on a 401(k) loan during 2022, you have until the tax deadline (April 15, 2023) to make a contribution back to the same 401(k), or to a private IRA and have it considered a non-taxable rollover. For example, if the defaulted loan balance is $25,000, and you manage to make a $10,000 rollover contribution before April 15, then you would only have a deemed distribution of $15,000. The deemed distribution is subject to regular income tax plus a 10% penalty.
What this means is that you should carefully consider your investment and retirement options if you get a new job before April 15, 2023. Suppose you have the option of contributing to a 401(k) and your new job gives you sufficient financial resources to do that. If you make contributions to your new 401(k), you will get the tax deduction but you will pay income tax and the penalty on the default loan balance. However, if you took the money that you would have contributed to the 401(k) and put it in an IRA instead as a rollover contribution, you would not get a tax deduction, but you would avoid the income tax and the penalty on the deemed distribution. (If you do this, make sure you tell the IRA custodian that this is a rollover contribution due to a defaulted 401(k) and not a regular contribution.)
As the April 15 deadline approaches, you might also consider the idea of taking a short term bank loan to make the rollover contribution, because the interest on the loan would probably be a lot less than the tax and penalty on the deemed distribution, especially if your financial situation in 2023 would allow you to repay the loan easily.
So as far as your tax and withholding situation for 2022 are concerned, if you don’t think that you will be able to make a rollover contribution by April 15, 2023, you should plan to pay income tax and the penalty on the defaulted loan balance. However, if you can make rollover contributions to an IRA, that could significantly reduce the tax you owe.
Also note that the 401(k) administrator will probably not accept a rollover repayment if it is after 60 days. That’s OK because you can make the rollover contribution to a private IRA instead.
Would this be the same for a loan that defaulted in 2021, but was taken originally in 2020?
@Melisj2008 wrote:
Would this be the same for a loan that defaulted in 2021, but was taken originally in 2020?
It doesn't matter when you default, because it doesn't have anything to do with COVID. You can do a rollover of a loan offset up to the tax filing deadline.
When you have a 401(k) loan, you must make repayments by payroll deduction, it's a tax law requirement, and the repayment schedule can be as long as 5 or 10 years. If you leave the company before the loan is repaid, the remaining balance automatically goes into default. You have 60 days to repay the plan administrator, after that they will consider it an "offset distribution" and issue a 1099-R. However, you actually have until the tax filing deadline* to repay the loan. Since the original plan administrator will usually not accept repayment after 60 days, you make "repayment" by making a contribution to a new plan and calling it a "rollover." Then when you file your tax return and you enter the 1099-R for the offset, you can report that you rolled it over, and it won't be taxed.
(The filing deadline for 2021 is April 18, 2022, or October 15, 2022 if you get the automatic extension.)