Defined-contribution plan loan and hardship distribution rules eased

401(k)s are for retirement, but some clients who are strapped for cash need access now for any number of reasons. Advisers can help by knowing the latest tax rules.

Defined-contribution plans can offer loans and hardship distributions. While any defined-contribution plan can offer loans (including money purchase plans and profit-sharing plans), only 401(k), 403(b), and 457(b) plans can allow hardship distributions.

Remember though that hardship distributions only allow access to the plan funds. The distributions are still taxable and subject to the 10% penalty.

Hardship distributions are limited to the total amount of elective deferrals — employee contributions — made to the plan. However, the pool of money available for hardship distributions was recently expanded under the Bipartisan Budget Act of 2018.

Under the Act, qualified non-elective contributions, or QNECs, qualified matching contributions, or QMACs, and the earnings on salary contributions will also be available for hardship withdrawal. This new rule kicks in for plan years that start after Dec. 31.

The hardship distribution rules for 401(k) and 403(b) plans are slightly different from those for 457(b) plans. A 401(k) or 403(b) hardship must be made “on account of an immediate and heavy financial need.” While these plans could write their own hardship definition, most adopt the IRS safe harbor rules and consider the following as acceptable:

1. Medical expenses for the participant, their spouse, or dependents

2. Cost related to the purchase of a principal residence

3. Tuition and related educational fees and expenses for the participant, their spouse or dependents

4. Payments necessary to prevent eviction from, or foreclosure on, a principal residence

5. Certain burial or funeral expenses for the participant, their parents, spouse or dependents

6. Certain expenses for the repair of a principal residence

On the other hand, a 457(b) hardship distribution must be made “on account of an unforeseeable emergency.” While the language is a little different, all the standard IRS hardships above qualify under a 457(b) with two important exceptions — the purchase of a home and tuition-related expenses do not qualify as “unforeseeable emergencies” and are generally not eligible for hardship from a 457(b) plan.

On the positive side, the 457(b) definition gives plans a little more flexibility when deciding whether to allow a hardship distribution. In addition, unlike early hardship distributions from a 401(k) plan, distributions from a 457(b) plan are exempt from the 10% early distribution penalty.

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Plan Loan Rules

The loan rules are the same for all defined contribution plans. The repayment period must be five years (although it can be longer for loans for the purchase of a primary residence), and the loan repayments need to be made at least quarterly and include principle and interest.

Also, the loan cannot exceed the lesser of $50,000 or 50% of the participant’s vested account balance. The $50,000 is increased to $100,000 for certain federal disaster areas.

For primary residency loans, the IRS has approved a repayment period of 15 years. Many plans use this as a benchmark, though some limit all loans to a five-year repayment period. If the loan fails to meet any of these conditions, the unpaid balance is considered a deemed distribution.

The most common reason for a deemed distribution is the participant not staying current on the repayments. A deemed distribution is taxable, cannot be rolled over and is potentially subject to the 10% early withdrawal penalty.

There may also be a loan offset. This occurs when the loan is accelerated. The plan’s terms will dictate when the acceleration and offset occur. Some common ones are upon termination of service or when the participant requests a distribution. An offset distribution can be rolled over, while a deemed distribution cannot.

Effective Jan. 1, 2018, the Tax Cuts and Jobs Act extended the deadline for rolling over an offset distribution, due to termination of service or due to plan termination. Instead of occurring 60 days after the offset date, the new deadline is the due date for filing federal income taxes for the taxable year in which the plan loan offset occurs (including extensions). Good to know.

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Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group. He can be reached at irahelp.com.