Just when you thought the rules around COVID-19 distributions couldn’t get any more complicated…
For many households, “COVID-19 distributions” from qualified plans and IRAs may be a welcome backstop against financial challenges of the Coronavirus pandemic. The general rule is that a COVID-19 distribution is one that is received between Jan. 1, 2020, and Dec. 31, 2020, by an individual who has been diagnosed with the Coronavirus, is caring for a spouse or dependent diagnosed with the Coronavirus, or is experiencing adverse financial consequences due to certain pandemic-related situations (such as a quarantine). Under the CARES Act, to ease the federal tax burden, taxes on COVID-19 distributions, if elected, may be paid over three years. And COVID-19 distributions are not subject to the mandatory 20% withholding.
But those receiving those distributions (and those who process them) need to be aware of the potential sting of state tax liability due to differences between federal and state tax rules. To varying degrees, most state income tax regimes rely on the federal income tax regime, including the Internal Revenue Code and the associated Treasury regulations. That is, depending on the particular state, COVID-19 distributions may be currently subject to state taxes.
The impact of federal tax rules under state law depends on whether and how a state follows the Internal Revenue Code under its tax system. This varies from state to state, and all states selectively “decouple” assorted Code provisions. The results can be surprising. For example, for purposes of personal income tax, New York City and New York City State opted not to incorporate any Code amendments made after March 1, 2020, including CARES Act amendments. This means that if a participant who is subject to tax in New York receives a COVID-19 distribution in 2020, 100% of the distribution is taxed in 2020, regardless of the election for federal tax purposes.
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On the other hand, some states, by law, automatically follow the CARES Act. Others generally have to take action to adopt its provisions, including the three-year ratable income inclusion of the CARES Act. Ohio, for example, already enacted rules providing for the state to conform with federal law as it existed on March 27, 2020, the date the CARES Act was signed into law. This means that if a participant in Ohio elects ratable three-year inclusion in income of a COVID-19 distribution, their Ohio tax liability will be determined on the same basis. For states other than Ohio, new guidance is being published daily.
The bottom line is that differences in federal and state taxation can have a material impact on participants. Plan sponsors may wish to give employees a heads up regarding potential state tax liability when COVID-19 distributions are being taken to cover financial shortfalls.
Allison Wielobob is the General Counsel of the American Retirement Association.