Proposal Would Let Fraud Victims Reverse Taxes on 401(k) and IRA Withdrawals

People who are tricked out of money by scammers may face an added setback if they tap a 401(k) or IRA to cover the loss. Depending on age and circumstances, the withdrawal can trigger income tax and, in some cases, a 10% early-withdrawal penalty.

A bipartisan measure that cleared the House by a wide margin could ease that burden. The Tax Relief for Fraud Victims Act would create special rules for some scam victims, potentially letting them avoid the extra 10% tax, repay withdrawn retirement money, and seek refunds for taxes already paid.

Fraud-related withdrawals can trigger taxes and penalties

Money taken from a traditional 401(k) or IRA is generally taxable. If the account holder is under 59.5, an additional 10% tax may also apply unless an exception is available.

For example, a 50-year-old who takes a $25,000 fully taxable distribution after a qualifying fraud loss could owe $5,500 in federal income tax if the money falls in the 22% bracket, plus another $2,500 from the 10% additional tax.

That would mean $8,000 in federal taxes on top of the financial loss already suffered. Under the same simplified assumptions, a $50,000 withdrawal could generate $11,000 in ordinary federal income tax and another $5,000 from the extra 10% tax.

The bill would carve out an exception to the 10% penalty

The Tax Relief for Fraud Victims Act, introduced by Reps. Max Miller and Tom Suozzi, would create a new exception to the 10% additional tax for qualifying retirement distributions tied to theft involving fraud, deceit or misrepresentation.

Using the examples above, the proposal could erase $2,500 in extra federal tax on a qualifying $25,000 withdrawal or $5,000 on a $50,000 withdrawal.

The measure would apply to eligible withdrawals made after December 31, 2020, which means some taxpayers who already paid the extra tax could potentially qualify for relief.

Repayment of withdrawn retirement money could also help

The proposal would go beyond the penalty exception. It would also allow qualifying fraud-related distributions to be repaid into an eligible retirement account.

In general, the repayment period would last one year starting the day after the loss is discovered. That could matter for people who later recover stolen funds, receive compensation or rebuild enough savings to restore what they withdrew.

Repaying an eligible distribution could also allow some taxpayers to recover part of the ordinary income tax they previously paid on the amount returned, depending on their situation.

Refund claims on past penalties could get more time

The House-passed bill would also extend the filing window for refund claims involving the 10% additional tax on qualifying retirement distributions. In general, that deadline could not expire before one year after the taxpayer discovers the qualifying loss.

There is also special treatment for people who discover the fraud before the bill becomes law. In those situations, the legislation generally uses the enactment date to start the new one-year window. As a result, someone who withdrew retirement money years ago and believed the refund deadline had already passed could get another chance to file.

Not every scam-related withdrawal would be covered

The legislation would not wipe out taxes on every scam-related withdrawal. A distribution would have to satisfy the bill’s qualifying fraud-loss standards.

That matters because the details of the fraud, the withdrawal and the loss could determine whether the special retirement-account rules apply.

The bill also includes broader changes to theft-loss deductions, though those provisions are secondary to the retirement-account issue. The main point for anyone who used a 401(k) or IRA is that qualifying withdrawals could receive penalty relief along with new repayment and refund options.

No need to amend a return yet

None of this relief is available yet. The House approved the Tax Relief for Fraud Victims Act by a 408-17 vote, and the Senate later received H.R. 9500 and referred it to the Finance Committee, where it remains.

Until the measure becomes law, people who paid tax on a fraud-related retirement withdrawal should not assume those taxes can already be recovered.

Still, keeping records may be wise for anyone who withdrew money from a retirement account because of fraud since 2021. Useful documents could include tax returns, 401(k) or IRA statements, distribution records, evidence of the fraud and proof of when the loss was discovered.

Those records could become especially important because the bill’s repayment and refund periods are tied to the date the fraud was discovered.

Bottom line

The Tax Relief for Fraud Victims Act could give some scam victims a chance to revisit taxes paid after withdrawing money from a 401(k) or IRA. It could also allow eligible repayments and refund claims involving the 10% additional tax, with possible income-tax relief when qualifying distributions are repaid.

The bill is not yet law, but its retirement-account provisions would reach back to qualifying distributions made after 2020. Taxpayers affected by fraud may want to hold onto their retirement and tax records rather than assume those past bills are final.