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2009 CCH Whole Ball of Tax
Rules – and Penalties – for Tapping 401(k)s May Soften in 2009, But Still Apply for 2008 Tax Returns, Says CCH
(RIVERWOODS, ILL., January 2009) – As millions of Americans watched their retirement account balances plummet in 2008, personal cash constraints may have led many employees to consider tapping their diminished 401(k) accounts to cover immediate, pre-retirement needs, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and pension information, software and services (CCHGroup.com). Meanwhile, regulations governing 401(k)s forced millions of seniors to further reduce their stressed accounts by taking required minimum distributions that, because they were based on the prior year’s account balance, may have seemed disproportionate to the size of the current account.
In difficult times, with retirement a future concern, 401(k) accounts may seem like an attractive source of immediate income. However, while distribution-related retirement savings rules may be modified in 2009 to authorize greater access to hardship distributions, CCH Senior Pension Law Analyst Glenn Sulzer, JD, cautions taxpayers to be careful in using retirement savings for immediate living expenses absent urgency or emergency conditions.
“Many people who needed to tap into their retirement accounts may already have done so. Accordingly, in addition to the opportunity cost of having a further reduced account balance, such taxpayers now face paying taxes and penalties on withdrawals or repaying a loan with interest. The even greater challenge is for others to restrain from using retirement savings unless it’s absolutely unavoidable, even if the rules for doing so are relaxed,” said Sulzer.
Below, CCH provides an analysis of the 401(k) distribution rules that apply for 2008 tax returns and highlights possible changes that may be enacted in 2009 based on current proposals from the new administration. Many of these rules also apply to IRAs and other qualified retirement plans.
In 2008, individuals were allowed to contribute up to $15,500 to a 401(k) plan and $5,000 more as a catch-up contribution if they were 50 years of age or older. For 2009, this increases to a $16,500 contribution with a $5,500 catch-up.
Most employees do not contribute the maximum amount to their retirement accounts, electing to reserve funds for more immediate day-to-day living expenses. However, in the event a taxpayer needs to access retirement funds, options are limited, absent retirement, death, disability, severance from employment or hardship, the termination of the plan, or (in the case of a profit-sharing plan) the participant’s attainment of age 59½. The two most common sources of in-service distributions are hardship withdrawals and plan loans.
A hardship distribution may be authorized only if the employee has an immediate and heavy financial need, the distribution is necessary to satisfy the need and the distribution does not exceed the amount necessary to satisfy that need.
The plan must set forth nondiscriminatory and objective standards for determining whether an immediate and heavy financial need is present and the amount necessary to satisfy the need. As an alternative, most plans use a safe harbor prescribed by the IRS that permits hardship distributions under defined circumstances.
Authorized distributions under the safe harbor include the payment of medical expenses incurred by the employee, employee’s spouse, dependent and beneficiaries other than spouses and dependents, such as siblings or domestic partners. Other examples of expenses and circumstances justifying hardship distributions include:
- post-secondary tuition of employee, spouse, children or dependents for the next 12 months (not prior year);
- costs related to the purchase of the employee’s principal residence;
- costs associated with avoiding eviction or foreclosure;
- burial or funeral expenses; or
- expenses for the repair of casualty damage to the employee’s principal residence.
Rules governing 401(k)s are designed to dissuade employees from taking hardship withdrawals. Any hardship distributions are generally included in the employee’s income and subject to income tax as well as the 10-percent penalty on early distributions. The amount withdrawn cannot exceed the amount needed to address the hardship, but it can include any amount needed to pay taxes or penalties resulting from the distribution.
In addition, under the safe harbor, the employee must have obtained other currently available distributions (including plan loans) before qualifying for a hardship distribution. By the terms of the plan, the employee also must be prohibited from making elective deferrals to the plan and all other plans maintained by the employer for at least six months after receipt of the hardship distribution. Thus, not only is the employee not required to repay the distribution, he is also prohibited from replenishing the distributed amount for six months. While employees may increase deferrals after the suspension period has passed, they also assume the risk of a permanently reduced account balance.
Hardship rules may be amended in 2009 based on the new administration’s agenda outlined in late 2008. Under that proposal, the hardship rules would be relaxed for a limited period to allow distribution of 15 percent, up to $10,000, from retirement accounts without the 10-percent penalty, although income tax would still be due.
“Although such a stop-gap measure may be necessary, lawmakers remain concerned that authorizing $10,000 hardship withdrawals without penalty will encourage employees to treat retirement accounts less as last resort and more as a first option for addressing immediate needs. This perspective would result in already battered retirement accounts being further diminished,” said Sulzer.
While hardship withdrawals can only be made for very specific reasons to meet an immediate financial need, loans against a retirement account balance can be taken for any reason. In addition, an employee is not subject to income tax or penalty tax on a loan, as long as it is repaid on time and with interest.
Although more accessible than hardship distributions, the following restrictions apply to loans: the amount of the loan may not exceed the lesser of $50,000, or the greater of one-half of the present value of the participant’s account or $10,000; the loan (other than a loan used to acquire a personal residence) must be repaid within five years; and the loan must be amortized on a level basis with payment made at least quarterly. Additionally, if an employee (voluntarily or involuntarily) leaves the employer that sponsors the plan, the employee generally must pay back the loan within 60 days.
An employee who does not repay the loan as required will be subject to a 10-percent penalty and required to pay taxes on the amount of the loan.
“An employee may be confident he or she can repay the loan, but there’s a lot that can happen. For example, employees could be unexpectedly terminated, requiring a quick payback of the loan that puts them in an even more tenuous financial position,” said Sulzer. “Many financial advisors also believe that pulling money out now means there will be less available in the employee’s account to experience any potential uptick in the market, further hurting retirement savings.”
Two notable exceptions from the general loan requirements apply to loans for a principal residence and loans to military personnel:
- The terms of a loan for the purchase of a principal residence may provide for a repayment period beyond five years. Note, however, that neither a home improvement loan nor refinancing qualify as a principal residence loan.
- If an employee is in the military, a plan may (but is not required to) suspend an employee’s obligation to repay a loan during the period of the employee’s military service.
Required Minimum Distributions Unchanged for 2008, Suspended in 2009
As individuals head into their retirement years, their focus shifts to the effective management of what they’ve saved throughout their lives. Assuming they still have some exposure to equities, this task can be extremely challenging when the market is volatile.
Individuals participating in traditional 401(k) plans (as well as IRAs) are required to start taking distributions on April 1 of the calendar year following the year they reach age 70½ or they retire, whichever occurs later. Participants who also are 5-percent owners in the company with the 401(k) cannot hold off on taking a distribution by continuing to work; rather, they are required to begin taking distributions on April 1 of the calendar year after they turn 70½.
Individuals can either take the entire lump sum at that point or begin receiving payments over a period of time designed not to exceed the lifetime of the individual or their beneficiary. IRS regulations define the amount of the required minimum distribution (RMD) pursuant to a Uniform Lifetime Table or Single Life Table.
Seniors are subject to income tax on the amount of their distributions. Taxpayers also are generally advised to take only as much distribution as needed or required to sustain their lifestyle.
The challenge for retirees trying to manage their savings is that the minimum distribution is calculated based on the value of their accounts one year prior to the year of distribution.
Thus, an individual who turned 70½ in 2007 was required to begin receiving required minimum distributions in 2008. However, the required distribution was based on the value of the individual’s retirement account as of the end of 2007 which, given the stock market plunge, likely greatly exceeded the value of the account at the end of 2008. As a result, the amount of a minimum distribution taken, for example, in December 2008 would constitute a higher percentage relative to assets than the amount determined under the calculation required at the end of 2007.
Although the amount required to be taken out by a participant at age 70½ may, because of projected life expectancy, be a small percentage of the account balance (e.g., 3-4 percent), that amount is still being taken from a substantially reduced account.
In December of 2008, Congress passed the Worker, Retiree and Employer Recovery Act of 2008, which provides for a temporary one-year suspension of the required minimum distribution rules in 2009.
Typically, the IRS imposes an excise tax of 50 percent to the extent a required minimum distribution in the proper amount is not made. Under the new law, that excise tax is waived on all 2009 RMD underpayments ordinarily distributed to retirees.
The new law provides a temporary waiver of the minimum distributions from 401(k)s and IRAs that are required for 2009. Under the relief, any minimum distribution that would otherwise be required for 2009 need not be made. The next required minimum distribution would be for 2010.
For example, if an individual attains age 70½ in 2009, a required minimum distribution would not need to be made by April 1, 2010. However the distribution would need to be made by the end of 2010. Similarly, individuals who have been receiving required minimum distributions, because they attained age 70½ or retired in an earlier year, may waive the distribution for 2009 without incurring excise tax. Alternatively, a distribution taken in 2009 may be rolled over into an IRA or other eligible retirement plan as long as the distribution is not for 2008.
According to Sulzer, it is important to stress that the relief does not apply to distributions that are required to be taken in 2009 by an individual who attains age 70½ in 2008, as that distribution would be for 2008 and not 2009.
In addition, an individual is not required to waive the minimum distribution. Retirees who need the funds to meet living expenses may not be able to do without the funds, regardless of the tax consequences or the effect on their retirement accounts. Alternatively, however, a retiree may be able to elect a partial minimum distribution, under which they would incur income tax, but avoid excise tax on the amount of the generally required minimum distribution for 2009 that was not taken.
As a result, Sulzer noted, a retiree with a $10,000 required minimum distribution for 2009 could choose, for example, to take just a $2,500 distribution. The individual would not be subject to the typical 50-percent tax on the $7,500 of the distribution not taken as the rule is suspended in 2009; he or she would, however, still need to pay any income tax owed on the amount of the distribution taken.
(CCH issued a Tax Briefing: Worker, Retiree and Employer Recovery Act of 2008 on December 12, 2008, which is available at: CCHGroup.com/legislation/2008-Work-Retire-Act.pdf.)
Saver’s Credit Could Be Silver Lining
Despite a gloomy 2008 retirement savings picture, many taxpayers may be able to take some solace in learning they are eligible for the Saver’s Credit. However, this is not an automatic credit – eligible individuals need to be aware of the requirements and use IRS Form 8880 to claim the credit.
The Saver’s Credit is a nonrefundable tax credit that allows middle-income 401(k) plan participants to use elective contributions to the plan (up to $2,000 per year) to reduce their federal income tax on a dollar-for-dollar basis. Note, the Saver’s Credit is provided in addition to the exclusion from gross income afforded participants making elective deferrals.
The credit (up to $1,000 per year for each eligible individual) is available to married couples filing jointly whose AGI in 2009 is $55,000 ($53,000 in 2008) or less, head of household filers with an AGI of $41,625 ($39,750 in 2008) or less and single filers whose income is $27,750 ($26,500 in 2008) or less.
Depending on income, the credit ranges from 10 percent to 50 percent with lower income taxpayers being eligible for a higher credit. For example, a married taxpayer filing jointly with AGI of $33,000 or less making a $2,000 contribution to a 401(k) plan could be eligible for a 50-percent credit, or $1,000 in 2009. By contrast, a married taxpayer filing jointly with AGI of between $33,001 and $36,000 making a $2,000 contribution could be eligible for a 20-percent credit or $400 in 2009, while a married taxpayer with AGI between $36,001 and $55,500 would receive a 10-percent credit or $200 for this year.
The Saver’s Credit also applies to contributions to IRAs, Roth IRAs, SIMPLE plans and other qualified retirement plans.
About CCH, a Wolters Kluwer business
CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, accounting and audit information, software and services. It has served tax, accounting and business professionals since 1913. Among its market-leading products are The ProSystem fx® Office, CorpSystem®, CCH® TeamMate, CCH® Tax Research NetWork™, Accounting Research Manager® and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill.
Wolters Kluwer is a leading global information services and publishing company. The company provides products and services globally for professionals in the health, tax, accounting, corporate, financial services, legal and regulatory sectors. Wolters Kluwer has annual revenues (2007) of €3.4 billion ($4.8 billion), maintains operations in over 33 countries across Europe, North America and Asia Pacific and employs approximately 19,500 people worldwide. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. For more information, visit www.wolterskluwer.com.
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EDITORS' NOTE : New legislation related to 401(k) plans is expected in 2009. CCH provided initial review of these issues in a 2008 Tax Briefing (CCHGroup.com/legislation/ObamaTaxPolicies.pdf) and will provide further analysis on any proposals as they are developed into regulation. Updates will be posted to the 2009 CCH Whole Ball of Tax (www.cch.com/wbot2009) site as they occur.