The Internal Revenue Service (IRS) issued an announcement and notice on September 15th addressing loans and hardship distributions from retirement plans (such as 401(k) plans, 403(b) plans maintained by tax-exempt organizations, and governmental 457(b) plans). The announcement relaxes certain requirements for loans and hardship distributions and stresses the IRS’s interest in providing “broad-based relief” and minimizing “red tape.” The Department of Labor (DOL) has also issued a statement indicating that it will not treat any person as having violated the provisions of Title I of the Employee Retirement Income Security Act solely because they complied with the provisions of the IRS announcement.
The laws relating to tax-qualified plans impose various limitations on distributions and loans. Certain plans, such as 401(k), 403(b), and governmental 457(b) plans, may permit loans and hardship distributions. However, the plans must contain language permitting the loans and hardship distributions. Hardship distributions and loans must also meet certain regulatory requirements. Furthermore, if a hardship distribution is made, it is includible in the employee’s gross income and generally subject to a 10-percent penalty tax, although Congress is currently considering possible modifications to this tax. Hardship distributions as well as loans must meet certain verification procedures. Ordinarily, retirement plan loan proceeds are tax-free if they are repaid within five years.
According to the announcement, a plan will not be treated as failing to satisfy requirements under the Internal Revenue Code (Code) and regulations because the plan makes a loan or a hardship distribution for “a need arising from Hurricane Katrina” to an employee or former employee (i) whose principal residence on August 29, 2005, was located in one of the counties or parishes in Louisiana, Mississippi or Alabama that have been or are later designated as disaster areas, (ii) whose place of employment was located therein on such date; or (iii) whose lineal ascendant or descendant, dependent or spouse had a principal residence or place of employment therein on such date.
As a result, a retirement plan may allow a Katrina victim to take a hardship distribution or borrow up to the specified limits from their retirement plan to repair or replace a home or for another hardship—even if it does not fall within the types of hardships listed in the IRS regulations. It also means that a person who lives in another part of the country can take out a retirement plan loan or hardship distribution and use it to assist a son, daughter, parent, grandparent, or other dependent who lived or worked in the disaster area.
To qualify for this relief, a hardship distribution must be made “on account of a hardship resulting from Hurricane Katrina” and must be made on or after August 29, 2005, but no later than March 31, 2006. Plan loans must still satisfy the requirements of Code Section 72(p). Plan administrators may rely on representations from the employee or former employee as to the need for and amount of a hardship distribution, unless the plan administrator has actual knowledge to the contrary. A plan, such as a profit-sharing or stock bonus plan, that currently does not provide for hardship distributions may nevertheless make Katrina-related hardship distributions, provided it is ultimately amended. A defined benefit or money purchase plan, which generally cannot make in-service hardship distributions, still may not make hardship distributions, except from a separate account, if any, within such plan containing either employee contributions or rollover amounts.
The amount available for hardship distribution is limited to the maximum amount that would be available for a hardship distribution under the plan under the Code. However, the relief applies to any hardship of the employee--not just the types enumerated in the regulations, and no post-distribution contribution restrictions are required. For example, regulations under Section 401(k) provide safe harbor hardship distribution standards wherein a hardship is deemed to exist only for certain enumerated events, and, after receipt of the hardship amount, the employee is prohibited from making contributions for at least 6 months. Under the relief, plans generally do not need not follow these requirements.
A retirement plan will not be treated as failing to follow procedural requirements for plan distributions or loans imposed by the terms of the plan merely because such requirements are disregarded for any period beginning on or after August 29, 2005, and continuing through March 31, 2006, provided the plan administrator makes a good-faith effort under the circumstances to comply with the requirements. However, as soon as practical, the plan administrator must make a reasonable attempt to assemble any foregone documentation. For example, if spousal consent is required for a plan loan or distribution and the plan terms require production of a death certificate if the employee claims his or her spouse is deceased, the plan will not be disqualified for failure to operate in accordance with its terms if it makes a distribution or loan in the absence of a death certificate if it is reasonable to believe, under the circumstances, that the spouse is deceased, the distribution is made no later than March 31, 2006, and the plan administrator makes reasonable efforts to obtain the death certificate as soon as practical.
If the plan does not provide for loans or hardship distributions, the plan must be amended to provide for loans or hardship distributions no later than the end of the first plan year beginning after December 31, 2005. For a calendar-year plan, the amendment would need to be made by December 31, 2006.
In compliance with Internal Revenue Service Circular 230, we advise you that any advice herein relating to U.S. federal income taxes is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under the U.S. Internal Revenue Code.