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Leslie Bonacum
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Visit the CCH Whole Ball of Tax site often as new releases and other updates will be posted throughout the tax season.

CCH provides special CCH Tax Briefings on key topics at: CCHGroup.com/Legislation/Briefings.

• CCH Tax Briefing: 2010 Hiring Incentives to Restore Employment Act
• CCH Tax Briefing: FY 2011 Federal Budget - Tax Proposals
• CCH Tax Briefing: Haiti Earthquake Relief
• CCH Tax Briefing: Return Preparer Oversight
• CCH Tax Briefing: Senate Passes Health Care Reform Legislation
• CCH Tax Briefing: House-Passed Extenders/Jobs Bills Await Senate Action in 2010
• CCH Tax Briefing: Estate Tax Extension Passes House, Fails in Senate; Carryover Basis to Be Effective January 1, 2010
• CCH Tax Briefing: Worker, Homeownership, and Business Assistance Act of 2009
• CCH Tax Briefing: Treasury Releases “Green Book” of Tax Proposals
• CCH Tax Briefing: President Signs Massive Stimulus Bill; Nearly $300 Billion in Tax Relief

Look Before Leaping: Tapping 401(k) Savings Has Short- and Long-term Impacts, Says CCH

(RIVERWOODS, ILL., January 2010) – Many people struggled in 2009 to pay down debt while facing unpaid furloughs or pay cuts and less access to conventional and home equity loans. As a result, tapping 401(k) accounts may have been one of the last possible alternatives for these taxpayers, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and pension information, software and services (CCHGroup.com). 

Generally, when employees want to tap their 401(k) accounts, they have two options, according to CCH Senior Pension Law Analyst Glenn Sulzer, JD. They can either take a loan that must be repaid or, barring other options, take a hardship distribution that does not need to be repaid. There is the missed opportunity for investment growth and compound interest caused by diminishing – even temporarily – their retirement savings and there are potential tax consequences and penalties in both cases. 

“Laws governing retirement plans are designed to ensure people are saving for retirement,” said Sulzer. “ Consequently, people who really need the funds may face obstacles in accessing their money. However, the alternative would be even fewer people successfully saving for retirement.”

Even the regulators, though, have a heart. While the broad relaxation of distribution rules that had been discussed in early 2009 was not enacted, there is bipartisan support to eliminate a current rule that prohibits employees who have taken a hardship distribution from making contributions to their plans during the six months after receiving the distribution.

Below, CCH outlines the rules and tax implications of taking loans and hardship distributions from 401(k) plans. Many of these rules also apply to IRAs and other qualified retirement accounts. 

Loans – Easier to Get But Tough Penalties If Not Repaid

The first option – and easiest to qualify for – is to take a loan. Subject to plan terms, employees generally can borrow from their retirement account balance for any reason. In addition, an employee is not required to pay income tax or penalty tax on a loan, as long as it is repaid on time and with interest.

However, certain restrictions do apply. These include:

• 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.

The consequences are stiff for not repaying the loan as required. In the event the participant fails to make the required payments, a deemed distribution of the remaining loan balance occurs at the time of the default. The employee would be subject to a 10-percent penalty and required to pay taxes on the amount of the loan. However, a plan may allow a participant a cure period in which to make a required installment payment.

In addition, it is important to stress that the termination of employment does not excuse an employee’s obligation to repay a plan loan. Plans typically require an employee to repay the remaining unpaid amount of the loan upon the termination of employment or offset the distribution of the participant’s account balance by the amount of the outstanding loan, subjecting the employee to income tax and possible penalty tax.

“With unemployment topping 10 percent at the end of 2009, some employees who earlier took loans from their retirement plans and are now out of work may be facing unexpected taxes and penalties if they are not able to quickly repay the loan,” said Sulzer.

Two exceptions from the general loan requirements include rules on 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. However, neither home improvement loans nor refinancing qualify as principal residence loans; and

• 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.

Hardship Distributions for Tough Times

Unlike a loan, a hardship distribution does not need to be paid back. However, there are tougher qualification requirements and stiffer near-term tax and penalty ramifications.

Hardship distributions can only be taken when the employee has an immediate and heavy financial need, the distribution is necessary to satisfy the need and the distribution amount is not more than necessary to satisfy that need. 

401(k) plans are required to have nondiscriminatory and objective standards for determining whether an immediate and heavy financial need is present and the amount requested is necessary to satisfy the need. The option, followed by most plans, is to 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 for the employee or the employee’s spouse, dependent and other beneficiaries, such as siblings or domestic partners. Examples of other expenses 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; and

• Expenses for the repair of casualty damage to the employee’s principal residence.  

In addition, under the safe harbor, the employee must have obtained other currently available distributions (including plan loans) before qualifying for a hardship distribution.

Hardship distributions come at a high cost. The distribution amount is generally included in the employee’s income and subject to income tax as well as the 10-percent penalty on early distributions. While the amount of a hardship distribution cannot exceed the amount needed to address the hardship, it can include the amount needed to pay taxes or penalties resulting from the distribution. 

In addition to the specific tax and penalty costs, hardship distributions also carry a significant missed opportunity cost. Not only has the employee removed money from his or her retirement account, the employee also is prohibited from making elective deferrals to the plan and all other plans maintained by the employer for at least six months after receiving a hardship distribution.

According to Sulzer, that may soon change. A proposal to eliminate the six-month prohibition on contributions after taking a hardship distribution appears to have bipartisan support and could be enacted sometime during 2010.

“Getting people to regularly contribute to retirement plans is difficult enough,” said Sulzer. “The six-month prohibition on contributions after a distribution is a penalty that lawmakers now recognize may be counter-productive to the underlying intent of tax-advantaged retirement savings plans – namely to save for retirement.”

The maximum amount people can contribute to their 401(k) plans for 2009 was $16,500 and $5,500 more as a catch-up contribution if they were 50 years of age or older. This remains unchanged for 2010, but remains substantially more than the $5,000 maximum IRA contribution.

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. CCH is based in Riverwoods, Ill. Wolters Kluwer is a leading global information services and publishing company. Wolters Kluwer is headquartered in Alphen aan den Rijn, the Netherlands (www.wolterskluwer.com).

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