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Jeffrey R. D’Amico
Hurricane Sandy relief through retirement plan hardship distributions and loans

Why a hardship distribution may not be a good move for people in need after the hurricane.

December 13, 2012
by Jeffrey R. D’Amico, J.D., LL.M.

In response to the devastation caused by Hurricane Sandy, the IRS issued Announcement 2012-44, which sets forth rules under which taxpayers can use retirement plan funds to obtain a hardship distribution or plan loan to help manage the financial impact of the natural disaster. The relief applies to any Sec. 401(a), 403(a), or 403(b) plan that could, if it contained enabling language, make hardship distributions. It also applies to any Sec. 457(b) plan maintained by an eligible employer, and any hardship arising from Hurricane Sandy will be treated as an “unforeseeable emergency” for purposes of distributions from such plans.

This may seem like a quick and relatively painless way for a taxpayer to access funds needed to cope with the storm’s impact by bypassing the red tape and bureaucracy of programs such as FEMA grants and/or the requirements of private insurers and possibly of banks holding the mortgage on the taxpayer’s home. However, before seeking a retirement plan hardship distribution or loan, the taxpayer needs to understand how to apply for this relief and understand the different consequences of taking a loan or a distribution. This will help avoid making a bad situation worse.

Applying for a retirement plan hardship distribution or loan

According to Announcement 2012-44, to obtain a retirement plan distribution or loan, the taxpayer must be eligible for the relief. To qualify, a taxpayer must have a residence or place of employment in specified parts of Connecticut, New Jersey, New York, or Rhode Island (or be related to someone in that area, see below). The taxpayer needs to contact the retirement plan administrator, complete the plan’s paperwork, and obtain the relief by Feb. 1, 2013.

Announcement 2012-44 streamlines the application process for loans and distributions by:

  1. Allowing retirement plans that wish to make hardship distributions or loans to eligible taxpayers to make the relief available. If the retirement plan does not include provisions for allowing such relief, relief can still be granted, but the plan must be amended to include those provisions, which must be done by the end of the 2013 plan year; and
  1. Allowing retirement plans that wish to make loans to eligible taxpayers to make those loans without following the plan’s procedural requirements to do so as long as the plan administrator makes a reasonable good-faith effort to obtain the necessary documentation as soon thereafter as possible.                          

Therefore, a plan administrator may rely on the taxpayer’s representation of how much is needed (the hardship or loan amount) unless the administrator has actual knowledge to the contrary and may also rely on the taxpayer’s representation that the spouse is deceased, if no death certificate is available, if it is reasonable to believe, under the circumstances, that the taxpayer’s spouse is deceased (where spousal consent is required to make a distribution and the plan requires production of a death certificate if the employee claims the spouse is deceased).

Misconceptions

The announcement is helpful and valuable for an eligible taxpayer seeking Hurricane Sandy relief, but the IRS needs to address numerous substantive misunderstandings about the relief provided by the announcement.

The first and biggest misconception is that if a taxpayer obtains a hardship distribution under Announcement 2012-44, it will not be taxable. This is not true. A hardship distribution will be included in gross income, and if the taxpayer is under age 59½, the distribution will also be subject to the 10% penalty under Sec. 72(t). Only Congress has the power to provide relief from the 10% penalty, not the IRS, but to date no such relief has been forthcoming. For this reason, a taxpayer should consider taking a loan from the plan, which will not be taxable, instead of a distribution, if at all possible. If the taxpayer cannot repay the loan, the loan amount will be converted into a distribution on the date the taxpayer defaults, which may at least delay the tax hit.   

A second misconception about Announcement 2012-44 is that an otherwise eligible taxpayer who does not have a retirement plan to access for the hardship distribution or loan is out of luck. This is not true. The announcement states that a retirement plan participant outside the eligible relief area may access a plan to help an ascendant, descendant, dependent, or spouse of the participant who resided, or was employed, in the eligible area. For example, a retirement plan participant in Florida could access a plan to provide relief for the participant’s child in the Hurricane Sandy area.

A third misconception is that a taxpayer who resides, or was employed, outside the required IRS eligibility area to obtain relief under Announcement 2012-44 but who was economically harmed by the storm (e.g., a food supplier to a restaurant destroyed by the hurricane) cannot obtain retirement plan relief. This is not true. A taxpayer may also be eligible for a retirement plan hardship distribution or loan under the normal rules for obtaining such relief under Regs. Sec. 1.401(k)-1(d)(3), which require the “events” and “needs” tests to be satisfied.

Generally, the needs test requires a distribution to be made due to an immediate and heavy financial need. The regulation gives two distinct standards, either of which a taxpayer can meet to satisfy the needs test for a hardship distribution. First, whether a taxpayer has an immediate and heavy financial need can be determined by evaluating all the facts and circumstances. The second standard is a deemed immediate and heavy financial need, which includes medical expenses, college tuition, burial expenses, expenses to avoid eviction or foreclosure, and expenses to repair the taxpayer’s principal residence that would qualify as casualty deductions. Under the events test, taxpayers must also establish that the distribution is necessary to satisfy that financial need. This regulation may provide relief for taxpayers who were affected by Hurricane Sandy but are ineligible for relief under Announcement 2012-44.

A fourth misconception is that taxpayers who have an IRA can obtain a loan against their IRA. This is not true. IRA owners cannot obtain loans from their accounts. No exception to this rule has been placed in effect as a result of Hurricane Sandy. The relief in Announcement 2012-44 applies only to Sec. 401(a), 403(a), 403(b), and 457(b) plans.

Conclusion

Finally, the following unanswered questions about Announcement 2012-44 are (1) will Congress act to provide relief from the 10% penalty applicable to a hardship distribution for a taxpayer under age 59½; (2) must all available retirement plan loans be taken prior to a hardship distribution; and (3) will there be consequences to taxpayers who fail to supply a spouse’s death certificate when requested by plan administrators?

As taxpayers pick up the pieces from the hurricane, avoiding a storm from incurring unexpected taxes and/or penalties needs to be part of the relief effort.

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Jeffrey R. D’Amico, J.D., LL.M., is managing attorney of the law firm of D'Amico & Associates, PLLC, in Garden City, N.Y., and a visiting assistant professor in the Department of Accounting in Business Law at SUNY College at Old Westbury, in Old Westbury, N.Y.