Even when IRS says yes, company plans may say no

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The IRS recently released a letter from a taxpayer who had suffered damages to his property during Hurricane Irma. He’d sought disaster relief, which under the law allowed him to withdraw under favorable tax provisions from his Section 457 plan to make repairs on his home. Although this relief was clearly permitted under the law, his company plan refused.

IRS responded, stating: “A Section 457 plan is not required to make special distributions on account of Hurricane Irma, and even if it does, the plan may impose conditions on obtaining a distribution.”


It may sound like a mistake, but the IRS was right. Company plans don’t have to allow everything that’s permitted under the tax law. The man was out of luck.

We often tell clients about planning opportunities available to retirement plans citing tax law provisions or IRS rulings. But just because the law allows these maneuvers doesn’t mean that their company plans will. The retirement tax rules are unique in that this is one area of tax law where the actual law is more liberal that what is sometimes actually offered by 401(k)s and other company plans.

Financial advisors should be familiar with planning strategies that are optional for company plans, before you assure your clients that the strategy is available. The list may surprise you.

Retirement tax rules are unique in that it's one area where the actual law is more liberal than what is sometimes offered by 401(k)s.

  • Required beginning date – The tax code allows individuals to delay the first year’s Required Minimum Distribution until April 1 of the year after the client turns age 70½. That means if they turned 70½ in 2018, the first RMD isn’t actually due until April 1, 2019. All subsequent RMDs must be issued before Dec. 31.

However, plans are not required to give participants the ability to delay that initial RMD. In fact, many plans do not and simply process all RMDs before Dec. 31. They do this to ease administration and to remove the fear that an initial RMD will not be processed before the April 1 deadline.

  • Still working exception – Unbelievably, plans do not have to offer this popular exception to the RMD start date rules. Thankfully, there is some relief. First, the exception is widely used and is considered the norm. Second, the exception is actually the default rule under the tax code. Finally, under IRS guidance, RMDs that are issued while a person is still working for the company sponsoring the plan can be rolled over to an IRA, because they are technically not an RMD in this scenario.
Company plans don’t have to allow everything that’s permitted under the tax law. Without proper planning, a client may be out of luck.

Most advisors are unaware of this last point since it is set forth in a 1997 IRS Notice (Notice 97-75, A-10(c)), which was issued to clarify new rules added by the Small Business Jobs Protection Act of 1996. That act added the “still working” exception and made it the default rule. In Notice 97-75, the IRS ruled that if a plan did not adopt the exception and continued to force distributions at age 70½ for participants that are still working, those distributions are not required under the tax code. That means these distributions can be rolled over and will not trigger the 6% excess contribution penalty. However, the ability to defer taxes would only last for one year since the “still working” exception doesn’t apply to IRAs. Once the individual finally retires, the normal rules apply to any subsequent RMDs.

  • Stretch distributions – Plans do not have to offer the stretch distribution option to any beneficiaries under the plan, including the worker. However, most plans do offer the stretch to at least the employee and spouse beneficiaries. Quite often, this treatment is not extended to non-spouse beneficiaries. That means they would be forced to completely empty the account in five years. In such a scenario, the beneficiary should rollover the plan money into a properly titled, inherited IRA, thereby allowing them to stretch distributions over their life expectancy.

  • Designated Roth AccountsRoth accounts are after-tax accounts that can be offered by 401(k), 403(b) and 457(b) plans, but companies do not have to offer these. Just as with the pretax component of the plan, Roth contributions are elected at open enrollment and are then deposited into the plan when earned. However, the Roth plan could allow what’s called an in-plan rollover or in-plan conversion. This is a taxable transfer of pretax monies to a Roth account within the plan. If offered, the participant does not have to be eligible for a distribution of pretax funds to take advantage of the option. While the in-plan rollover is taxable and reportable (on Form 1099-R), it does not trigger the early distribution penalty or withholding requirements.
  • Hardship distributions – Plans are not required to offer hardship distributions, including any of the new disaster relief provisions passed by Congress. However, if the plan does offer hardship distributions, the disaster relief provisions themselves are optional – at least for now. Just recently, the IRS released new proposed hardship regulations that added a new distribution category and further liberalized some of the rules. The new distribution category is for expenses and losses incurred by an employee due to damage suffered to his or her home or place of employment due to a federally declared disaster. Plans can impose the new rule retroactively to Jan. 1, 2018. This would cover disasters that occurred earlier in the year, like Hurricanes Michael and Florence. However, plans are not required to apply the new rules retroactively.

Since the passage of the Pension Protection Act of 2006, Congress and the IRS have slowly loosened some of the onerous and unnecessary restrictions on hardship distributions. One of those restrictions required plans to suspend salary contributions for six months after a hardship distribution. The new proposed regulations eliminate this requirement beginning the first day of the plan year after Dec. 31, 2018 (i.e., Jan. 1, 2019, for calendar plans). However, plans have a choice: they can quit applying the provision for all outstanding hardship distributions or they can apply it only for distributions made after the effective date.

  • Plan loans – Just like hardship distributions, not only are plan loans themselves optional, but some of the additional features allowed under the tax code are as well. For example, plans can restrict participants to one outstanding loan or allow multiple loans to be taken out. However, unlike the new additions to the hardship rules, plans that offer loans are required to apply the new disaster relief provisions that were passed for the victims of the 2017 California wildfires and Hurricanes Harvey, Irma and Maria. These include the increase in the loan limit from $50,000 to $100,000 (or 50% of the vested benefit, whichever is less) and the one-year repayment delay. These new rules only apply to loans that are issued on or before Dec. 31, 2018.
  • In-service distributions – While elective deferrals (i.e., salary contributions) cannot be distributed until age 59½, death, disability or termination of service, other types of contributions have different rules. For example, contributions that were rolled over from another plan can be distributed at any time — if the plan allows. On the other hand, the plan could subject all contributions, including rollover money and after-tax contributions, to the salary contribution timeline discussed above. Therefore, it’s vital that workers understand a plan’s distribution rules for rollover contributions before making the election.

Example: Jamie begins working for a new company and is immediately eligible to participate in its 401(k) plan. Jamie has a 401(k) account from her previous employer and is thinking about rolling the funds into the new company’s plan. However, the new plan does not allow in-service distributions of rollover funds received from another plan. Therefore, Jamie would be better served by rolling the 401(k) funds to an IRA thereby continuing tax deferral on the funds while ensuring access to distributions, albeit subject to taxes and penalties. If the money were rolled to the new plan, her access would be severely restricted. Unless the plan allowed loans or hardship distributions, she wouldn’t be able to touch the funds until age 59½, death, disability or termination of service.

  • Rollovers into the plan – Speaking of rollovers, plans have the option to limit the types of funds that can be rolled into the plan. This includes prohibiting pretax IRA money from being rolled over. Why would someone want to roll IRA money into a qualified plan? There are many reasons. They could be looking for the additional creditor protection under ERISA. Older workers may want to avoid RMDs from their IRA by rolling the funds into a qualified plan of their current employer, thereby taking advantage of the “still working” exception, if the company plan allows that. Finally, individuals looking to convert nondeductible IRA contributions to a Roth IRA may want to roll the pretax IRA money into a qualified plan to isolate the after-tax IRA funds so they can be withdrawn or converted to Roth IRAs tax free. However, all these options are unavailable if the plan excludes rollovers from IRAs.
  • Direct rollovers out of the plan – Staying with the rollover theme, the tax code does not limit the number of direct rollovers that can occur in a single transaction. A taxpayer could directly rollover a distribution to five, 10, or even 20 different tax-deferred accounts. However, plans can limit the number of direct transfers. Some may only allow one direct rollover per transaction. This becomes vital if the account has both pretax and after-tax contributions. The withholding rules only apply to pretax amounts that are not directly rolled over. Money that’s withheld is considered taxable and subject to the 10% early distribution penalty.

Advisors should look to see which of these common options the clients’ company plans allow before providing advice on these issues.

This article originally appeared in Financial Planning.
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Retirement planning Tax planning Retirement withdrawals 401(k) Disaster planning RMDs IRS Practice Management Resource Center