If you withdrew money from your IRA during Covid, it may pay to pay it back

When the Covid-19 pandemic hit in 2020, many people took advantage of a federal tax break and withdrew money from their retirement accounts.

If they repay the funds — which are not required — by next year, they will also get another tax break.

Those who made such a withdrawal under the CARES Act of 2020 from their individual retirement accounts or work plan—401(k)s, 403(b)s, or 457(b)s—and repay all or part of it can receive a full refund of any income tax imposed on the withdrawal.

Many people needed financial relief at the beginning of the pandemic because they were laid off, their businesses closed or for other reasons. The Cares Act made an exception to the government’s policy to discourage early forays into retirement accounts by creating Coronavirus Related Distributions, or CRDs, and imposes no restrictions on how distributed funds can be used.

“If you have the money, it makes sense to pay off your CRD,” says Ian Berger, an IRA analyst at Ed Slott & Co., a tax consulting firm in Rockville Center, N.Y. “That way your retirement account will be restored fully.”

CRDs were made available in 2020 to qualified individuals with certain health or financial problems who felt it necessary to tap into their retirement accounts. If you, a spouse or dependent were affected by Covid, or if you experienced certain adverse financial consequences related to Covid, you could get up to $100,000 from your account.

Two payment methods

While the CRD was supposed to be phased out in 2020 and reported on IRS Form 1099-R, Congress eased the pain by providing two ways to pay the tax owed: Include the entire amount as taxable income in 2020 or spread the amount equally over a three-year period —2020, 2021 and 2022. Spreading was the most popular option because it more often opened up the possibility of paying lower taxes. Anyone under 59½ would also be exempt from the 10% early distribution penalty that would otherwise be required.

Those who choose to repay, however, must do so within three years of receiving the funds, starting the day after you received the funds. If you took a CRD on May 15, 2020, you have until May 16, 2023 to re-contribute to the distribution.

Such a rollover is considered either an outright transfer or a trustee-to-trustee transfer — and is therefore not a taxable event. And the once-a-year rollover restriction doesn’t apply to him. The repayment, moreover, would not count against the applicable contribution limits for any plan.

For example, if you made a CRD in 2020, included the entire amount as income that year, and decided to return it before the deadline, you would amend your 2020 tax return and attach IRS Form 8915-E to claim refund. That way, not only would your tax be lower, but it could also drop your 2020 income into a lower bracket.

It’s not for everyone

If you repay a CRD, the funds will continue their tax-deferred growth until you retire. Of course, repayment isn’t always the best option for everyone. Some people may have preferred to place the funds in an easily accessible “rainy day” account to accumulate emergency reserves.

Refunds of a CRD do not need to be made to the retirement account from which it originated. After all, you may no longer have that IRA, or you may have changed jobs and no longer participate in that company’s 401(k). So, money taken from an IRA can be rolled back into another IRA, or money taken from a 401(k) can be rolled back into an IRA.

Mr. Sloane is a writer in New York. You can reach him at reports@wsj.com.

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