Taylor Porter Tax Attorney Cautions Louisiana Flood Victims About Accessing 401(k) Loans, Hardship Distribution

By John McDermott, Partner

The Internal Revenue Service announced that 401(k)s and similar employer-sponsored retirement plans can make loans and hardship distributions to Louisiana flood victims and members of their families, but Taylor Porter tax practice group leader John McDermott cautions residents against going this route, if other funding sources available.

“There is no relief on the taxation of the distribution,” McDermott said. “A hardship distribution will be taxed as ordinary income and will be subject to an additional 10 percent tax if the recipient has not attained age 59 1/2. In my opinion, for tax and financial planning purposes, this is a not a good funding source for disaster relief if other sources are available.”

Participants in 401(k) plans, employees of public schools and tax-exempt organizations with 403(b) tax-sheltered annuities, as well as state and local government employees with 457(b) deferred-compensation plans may be eligible to take advantage of these streamlined loan procedures and liberalized hardship distribution rules. Though IRA participants are barred from taking out loans, they may be eligible to receive distributions under liberalized procedures.

The hardship waiver will be in effect until Jan. 17, 2017, to allow flood victims access to emergency funds to account for losses that began Aug. 11.

The IRS is also relaxing procedural and administrative rules that normally apply to retirement plan loans and hardship distributions. As a result, eligible retirement plan participants will be able to access their money more quickly with a minimum of red tape. In addition, the six-month ban on 401(k) and 403(b) contributions that normally affects employees who take hardship distributions will not apply.

This broad-based relief means that a retirement plan can allow a Louisiana flood victim to take a hardship distribution or borrow up to the specified statutory limits from the victim’s retirement plan. It also means that a person who lives outside the disaster area 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.

If the plan document does not already permit loans and hardship distributions, it must be amended to permit them before the end of the current plan year. However, under the relief provisions, plans may make loans or hardship distributions before the plan is formally amended. In addition, the plan can ignore the reasons that normally apply to hardship distributions, thus allowing them, for example, to be used for food and shelter. If a plan requires certain documentation before a distribution is made, the plan can relax this requirement as described in the announcement.

Ordinarily, retirement plan loan proceeds are tax-free if they are repaid over a period of five years or less. Under current law, hardship distributions are generally taxable. Also, a 10 percent early-withdrawal tax usually applies.