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George F. Bearup, J.D. Senior Legal Trust Advisor

27-Mar-18

Retirement Plan and IRA Hardship Distributions: Rule Changes in 2019

Take-Away: Hardship distribution rules from qualified plan retirement accounts [not IRAs] changed in February 2018  immediately on the heels of the 2017 Tax Reduction Act. One proposed change with the 2017 Tax Reduction Act that got dropped at the last minute just became the law in February 2018. This is just one more example of how the tax laws are a moving target, at best, and that the hard-and-fast rules  now in place to preserve savings until retirement years may not be nearly as immutable as the Congress has implied in the past when taxpayers are victims of natural disasters.

Background: Some qualified plans permit hardship distributions. They are not required by law, but such distributions are permitted as an option that is elected by the plan sponsor. Some old rules that limited the use of hardship distributions are changed by the new February law.

  • Effective Date: The new hardship distribution rules come into effect after December 31, 2018. Thus, they are not yet available to plan participants.
  • Plan Amendments: Most qualified plans that permit hardship distributions will have to be amended to implement these new rules.
  • Rule Changes:  Some of the key hardship distribution rule changes follow:
  • (i) Future Contributions Now Permitted:  Currently, once a participant receives a hardship distribution, he/she is prohibited from making future contributions to the qualified plan for the next six (6) months. The new law removes this 6 month contribution prohibition. This change was initially proposed to be included in the 2017 Tax Reduction Act, but never made the ‘final cut.’ It is now back and set to become the law beginning in 2019.
  • (ii) More Qualified Plans Authorized to Permit Hardship Distributions: Currently, not all qualified plans can permit hardship distributions. With the recent change in law more types of qualified retirement plans will be authorized to permit hardship distributions.
  • (iii) Expanded Source of Funds: Currently, only employee-participants can receive a hardship distribution from either their salary contributions to the qualified plan, or their own elective deferrals to the qualified plan. But hardship distributions cannot come either from earnings on the participant’s own contributions or from any other employer contributions. With the change in law hardship distributions will now include any qualified non-elective contributions, matching contributions, and the earnings on participant salary contributions, non-elective contributions, and qualified matching contributions.
  • (iv) No More ‘Last Resort’ Rule: Current law requires a plan participant to take a plan loan prior to accessing hardship distributions. But there was no reporting mechanism to enforce this last resort rule rendering it somewhat superfluous. Consequently, the new law eliminates this last resort hardship distribution rule, so plan loans no longer have to be taken before a hardship distribution.
  • (v) Future Relief: Similar to the new IRC 199A with regard to the 20% small business ‘profits’ deduction in the 2017 Tax Reduction, where Congress directed the Treasury to ‘write the rules’ to implement Congress’ intent, once again Congress  passed the buck to the Treasury. Congress directs the Treasury in this newest legislation to ‘make any changes necessary to ease the hardship distribution rules.’ This departure from the longstanding legislative policy designed to encourage taxpayers to save for retirement, e.g. the 10% penalty for early distributions prior to age 60 years, to arguably now facilitate plan participants to access their retirement savings prior to retirement, may be an indirect response to yet another change that appears in the 2017 Tax Reduction Act. Recall that Congress changed the deduction rules for casualty losses in the 2017 Tax Reduction Act. This qualified plan change has no effect on the other qualifications or conditions to deduct casualty losses (which only applies to federal disaster areas.) But it does authorize access to assets held in qualified plans as hardship distributions due to a casualty loss incurred by the plan participant.
  • Plan Loan Change: A corollary change, admittedly limited,  also applies to qualified plan loans. Again, a qualified plan does not have to permit loans to plan participants, but some plan sponsors elect to permit loans from account balances to plan participants. For those participants who are in federal disaster areas [recently expanded to include those who lost homes in California wildfire disaster areas] the plan loan limit [currently the lesser of $50,000 or 50% of the vested account balance] was increased to $100,000 and the 50% vested account balance limitation is dropped.

IRAs: It is important to reiterate that neither hardship distributions nor loans are permitted from IRAs. Loans and hardship distributions can only be taken from qualified plan accounts, and only when the qualified plan formally elects to include those provisions [loans; hardship distributions] in the qualified plan documentation.

That said, there seems to be a growing ‘crack in the wall’ when it comes to preserving the integrity IRAs until retirement, or limiting access to IRA account balances prior to retirement.  Part of the February legislation (implementing the 2018-2019 bipartisan Budget Act) expands relief to IRA owners who lost homes in the California wildfires who need to access their IRAs to rebuild their homes or who suffered economic loss as a result of that disaster, similar to the tax relief afforded to victims of Hurricanes Harvey, Irma and Maria. Those relief provisions include: (i) elimination of the IRA 10% early withdrawal penalty; (ii) the mandatory 20% tax withholding requirement on distributions from IRAs; (iii) spreading the taxable income associated with the IRA withdrawal ratably over three calendar years; and (iv) the ability to recontribute the withdrawn funds to the IRA within three years of the initial distribution from the IRA.

Observation: Each year we seem to suffer horrific natural disasters. Annually the Ohio River floods, causing millions, if not billions, of dollars in damage. We can almost predict the annual devastation caused by multiple tornadoes each spring and summer. Hurricane season in the Gulf of Mexico seems to come each year as well. My guess is that at some point, rather than Congress annually passing legislation that designates some geographic regions as worthy of relief, and by default other communities and regions as not-so-worthy of tax or penalty relief, that we may find that loans or hardship distributions will be permanently extended to IRAs, especially as America continues to age and baby boomers begin to roll their 401(k) balances into IRAs. Perhaps Congress’ direction the IRS to ‘make changes to ease the hardship rules’ from qualified plans is an initial step to permit taxpayers easier access to their retirement assets held in IRAs through loans or hardship distributions. Just a thought as we continue to see annual exceptions to the ‘normal’ rules for those victims of natural disasters.