As Republicans swiftly steered the prodigious Tax Cuts and Jobs Act through Congress at the end of 2017, the retirement plan community was on high alert since a mixture of game-changing and more moderate modifications to the rules for retirement savings were reportedly under consideration. Although several of the more moderate proposals, including changes to the hardship distribution rules, were included as the process unfolded, the final December tax bill ultimately contained only very minor changes for retirement plans.
Expansion of the hardship distribution rules
But just because an idea affecting retirement was left out of one tax bill does not mean it won’t resurface in the next tax bill. For example, the Bipartisan Budget Act of 2018 (BBA) signed by President Trump on February 9, 2018, revived a handful of the tax provisions related to retirement plans that had been dropped from the 2017 tax bill. Those changes included a significant expansion of the hardship distribution rules.
Depending on a plan’s design and future IRS guidance, it is likely that many plans may have to be amended if they choose to offer plan participants the added flexibility afforded by the changes.”
Prior to the BBA, plan sponsors could allow participants to take a hardship distribution from a 401(k) plan if the distribution was made on account of an “immediate and heavy financial need” and the distribution was necessary to satisfy that financial need. Under a regulatory safe harbor that many plans follow, a hardship distribution would be deemed as being necessary to satisfy such a financial need if the employee (1) obtained all other available distributions and nontaxable loans under the plan (and all other plans maintained by the employer) and (2) was prohibited from making contributions to any plan of the employer for six months after receiving the hardship distribution. Even if a plan does not follow the safe harbor, regulations still generally required a representation from the participant that the financial need cannot be satisfied by other distributions or loans from the plan.
The BBA makes two significant changes to those rules, effective for plan years beginning after December 31, 2018:
|•||Internal Revenue Code (IRC) section 401(k) is amended to provide that a distribution will not fail to be a hardship distribution solely because the employee does not take any available loan under the plan; and|
|•||The Treasury Department is directed to eliminate from the regulatory safe harbor the six-month prohibition on employee contributions following receipt of a hardship distribution.|
The former change effectively modifies both the safe harbor and non-safe harbor portions of the regulation requiring that a hardship distribution must be necessary to satisfy the participant’s immediate and heavy financial need. Furthermore, although the BBA explicitly addresses only 401(k) plans, the changes are generally expected to also apply to 403(b) plans because the existing 403(b) regulations provide that the rules for hardship distributions under section 401(k) apply to 403(b) plans.
In addition to relaxing the rules dictating what makes a distribution eligible as a hardship distribution, the BBA also substantially expands the types of assets a participant may withdraw from a plan on account of hardship. Today, under 401(k) and 403(b) plans, only the participant’s elective deferrals may be withdrawn on account of hardship. Effective for plan years beginning after December 31, 2018, participants demonstrating a qualifying hardship may also be allowed to withdraw the earnings on elective deferrals, qualified matching contributions (and related earnings), and qualified nonelective contributions (and related earnings).
Plan sponsors should also note some other ways in which other recent tax law changes could affect participants who take hardship distributions. First, Congress has passed a number of laws in recent months providing for disaster tax relief in response to Hurricanes Harvey, Irma, and Maria in 2017, certain disasters that were declared in 2016, and certain areas affected by California wildfires in 2017. The legislation generally allows distributions from retirement plans—including hardship distributions—to be eligible for relief that includes an exemption from the 10% early distribution penalty if the distribution was taken during certain time periods by a participant whose primary home was located in a specified disaster area and who experienced an economic loss due to the disaster. As with the changes to the hardship distribution rules made by the BBA, plan sponsors are generally not required to take action to help facilitate the availability of the disaster tax relief that Congress made available. But employers may nonetheless find themselves faced with participant questions on how to “reclassify” a prior hardship distribution as one that qualifies for the disaster tax relief.
Effect of tax reform on hardship distributions
Finally, another change that could affect hardship distributions is one that might be an unintended consequence of drafting the 2017 tax bill so quickly. The regulatory safe harbor for hardship distributions lists a number of events that are deemed to be on account of an “immediate and heavy financial need,” including expenses for repairing damage to the employee’s principal residence if the expenses would qualify for the Code’s casualty loss deduction under IRC section 165 (without regard to the 10% of Adjusted Gross Income threshold). But the section 165 deduction for casualty losses was substantially narrowed by the 2017 tax bill so that, for years 2018-2025, the deduction is now only available for losses attributable to a federally declared disaster. Although Congress may not have intended that change to affect the hardship distribution rules, until or unless the IRS issues guidance saying otherwise, plans that rely on the existing regulatory safe harbor would be safe to limit hardship distributions for principal residence casualty losses to those expenses incurred with respect to a federally declared disaster area.
With the 2017 tax bill and the 2018 BBA now behind us, retirement plan sponsors have generally been spared the need to make major changes to plans and procedures. However, the many implications of the seemingly modest changes in the hardship rules are a good reminder of the subtle, yet often thorny, complications that arise whenever Congress changes the law.
Randy Hardock is a regular columnist for Workplace Insights focusing on legislative and regulatory matters affecting employee benefit plans. He is a partner in the Washington, D.C., law firm of Davis & Harman, LLP, having previously served as Benefits Tax Counsel at the Treasury Department and as Tax Counsel to the Senate Committee on Finance. The opinions expressed are Mr. Hardock's and do not necessarily reflect the opinions of Bank of America Merrill Lynch.
Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.