A few weeks ago, I discussed the seemingly unintended impact the Tax Cut and Jobs Act (TCJA) had on the repayment of overpayments from employer plans. In essence, by eliminating the deduction of itemized miscellaneous expenses subject to 2% of adjusted gross income (AGI), the new law negatively impacted some repayments to employer plans – namely, repayments that are $3,000 or less. Similarly, by amending the tax code section on casualty losses, Congress has limited the ability of some plan participants to qualify for a casualty loss hardship distribution.
Background – Hardship Distribution in General
Employer plans are permitted to allow participants to withdraw their own contributions (i.e., elective deferrals) from the plan in the event of a hardship. Since we are talking about elective deferrals, then these rules only apply to 401(k) plans, 403(b) plans, and 457(b) plans. Employer contributions cannot be withdrawn due to a hardship. During the tax reform debate, the House actually proposed amending the hardship regulations to include employer contributions. However, that suggestion was not included in the final law so only elective deferrals remain eligible for a hardship distribution.
The regulations describe a hardship as an “immediate and heavy financial need” of the employee and his or her spouse and dependents. While plans are permitted to craft their own hardship definition, IRS regulations list six expenses that qualify for a hardship. Rather than create their own definition, most plans have adopted these safe harbor rules. In general terms, those approved expenses include:
- Certain medical expenses
- Costs relating to the purchase of a principal residence
- Tuition and related educational fees and expenses
- Payments necessary to prevent eviction from, or foreclosure on, a principal residence
- Burial or funeral expenses
- Certain expenses for the repair of damage to the employee’s principal residence
For this discussion, I want to focus on the last of the approved expenses – expenses for the repair of damage to the employee’s principal residence. As one might expect, the tax code goes into greater detail on this hardship expense. To qualify for this hardship, not only must the damage be to the employee’s principal residence (and not to a vacation or rental home), but it must also qualify for the casualty deduction under tax code Section 165. While the hardship regulations do specify that the 10% rule doesnot apply, all other rules under Code Section 165 do apply.
Impact under New Tax Bill – Limiting the Deduction for Casualty Losses
One of the changes under the TCJA was the limitation of the deduction for personal casualty and theft losses. Under the old law, a taxpayer could claim a deduction for certain casualty losses that were not reimbursed by insurance. Those losses had to be at least $100 and were only deductible to the extent they exceeded 10% of AGI.
However, under the new law, casualty losses are deductible only if the damage was attributable to a federally declared disaster (i.e., a disaster that is determined by the president to warrant federal assistance under the Robert T. Stafford Disaster Relief and Emergency Assistance Act). The $100 minimum and 10% of AGI rules continue to apply. This change applies to losses incurred after December 31, 2017.
While the law did not directly address hardship distributions, the change does impact administration for plans that have adopted the safe harbor hardship rules. Going forward, the casualty expenses must now be related to damage sustained in a federally declared disaster to qualify as a hardship. So, if your home floods and the damage isn’t covered by insurance, but it also isn’t due to a federally declared disaster, you cannot take a hardship distribution.
This “change” feels like an unintended consequence that may be remedied by the IRS. There doesn’t appear to be a fiscal reason to limit hardship distributions in this manner. Nevertheless, whether the IRS chooses to address this item remains to be seen. In the meantime, plan sponsors will need to update administration, and taxpayers should be aware of how this impacts access to employer plan funds via the hardship distribution.