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

• CCH Tax Briefing: 2012 Federal Budget Proposals
• CCH Tax Briefing: 2010 Tax Year-in-Review
• CCH Tax Briefing: 2010 Tax Relief/Job Creation Act
• CCH Tax Briefing: Sunsetting Benefits of the Economic Growth and Tax Relief Reconciliation Act of 2001
• CCH Tax Briefing: Small Business Jobs Act of 2010 (H.R. 5297)
• CCH Tax Briefing: Education/Jobs/Medicaid Assistance Act of 2010
• CCH Tax Briefing: Homebuyer Assistance and Improvement Act of 2010
• CCH Tax Briefing: Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act of 2010
• CCH Tax Briefing: Health Care Reform Act
• CCH Tax Briefing: 2010 Hiring Incentives to Restore Employment Act

CCH Notes Taxpayers Should Take Care to Follow Rules When Taking Loans or Hardship Distributions from 401(k) As Penalties Pack a Punch

(RIVERWOODS, ILL., January 2011) – While 401(k) savings are ideally held for retirement, many people struggling to get back their financial footing tapped these accounts in 2010 in order to avert a near-term crisis, such as eviction or medical emergencies, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and pension information, software and services (CCHGroup.com). 

Taxpayers who want to tap their 401(k) accounts generally can take either a loan that must be repaid or a hardship distribution that does not need to be repaid, but is subject to income and penalty taxes. Specific rules apply in both situations and, if not followed, can set an already struggling taxpayer back even further in fines and penalties.

As more plan sponsors move to online application processes for 401(k) loans and distributions, CCH Senior Pension Law Analyst Glenn Sulzer, JD, cautions there is more of an onus on the taxpayer to read the information presented and understand the applicable restrictions.

“Tax-advantaged retirement plans are designed to encourage people to save for retirement,” said Sulzer. “As a result, the rules governing when they can be used for another purpose are very restrictive and people need to clearly understand the applicable conditions before they attempt to take a loan or a hardship distribution.”

For example, while hardship distributions are allowed to address immediate foreclosure proceedings, they are not allowed just because a taxpayer is a few months behind on their mortgage payments. As a result, someone who took a distribution improperly could be required to repay the amount of distribution (plus earnings) to the plan. Employees who take loans and are subsequently let go or leave their job before repaying their loans may also find they’re subject to accelerated repayment or penalties .

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. 

Taking Loans Costly If Not Repaid

It’s easier to qualify for a loan than a hardship distribution as employees generally can borrow from their retirement account balance for any reason, subject to their plan’s terms. 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, another fine-print issue that may be surprising some people is the fact that if they are let go or leave their job, their plan can require accelerated repayment or convert the unpaid amount into a distribution, subject to income tax and possible penalty tax.

“With unemployment rates continuing to remain high, many people who earlier took loans could find themselves in a touchy situation,” said Sulzer. “If they are now out of work and unable to quickly repay the loan, they may find the loan was far more costly to them than anticipated.”

General requirements applying to loans from 401(k) savings 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. For example, the maximum loan amount someone with a $120,000 in 401(k) savings could take would be $50,000 (the maximum allowed); someone with $40,000 in 401(k) savings could take a loan of up to $20,000 (one-half their present 401(k) value); while someone with $15,000 in 401k savings could take a $10,000 loan;
• 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. If a participant misses a payment, a deemed distribution of the remaining loan balance occurs at the time of the default. The employee is then subject to a 10-percent early distribution penalty and required to pay taxes on the amount of the loan. Some plans may allow a participant a cure period in which to make a required installment payment.

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.

Taking a Hardship Distribution

Hardship distributions taken from 401(k) savings do not need to be paid back to the plan. However, they 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 follow their own set of rules to allow distributions. For example, they have to use 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. Examples of expenses justifying hardship distributions include:

• Medical expenses for the employee or the employee’s spouse, dependent and other beneficiaries, such as a sibling or domestic partner;
• 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 (but not commercial loans), before qualifying for a hardship distribution.

“Some people may want to take a hardship distribution because they don’t think they’ll be able to pay back a loan,” said Sulzer. “However, the rules and penalties governing retirement plans – including the applicable tax consequences – are designed to ensure that hardship distributions are used only as a last resort.”

While a hardship distribution may be unavoidable, it comes at a cost to the employee. 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.

Note, while the amount of a hardship distribution cannot exceed the amount needed to address the hardship, it may include the amount needed to pay taxes or penalties resulting from the distribution. However, this feature of the distribution must be authorized by the plan.

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.

The maximum amount people can contribute to their 401(k) plans for 2010 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 2011.

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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