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Contributed by J. Rose Zaklad, Groom Law Group, Chartered
The fallout from the coronavirus (Covid-19) pandemic and ensuing economic downturn is likely to put renewed attention on programs that permit employees to borrow or withdraw money from their retirement accounts. Participant loan and hardship withdrawal programs are exceptions to the general ban on permitting participants to access their 401(k) account balances before they terminate employment. During the Covid-19 pandemic, and resulting financial crisis, these exceptions have become more important than ever.
The checklist below summarizes the key requirements for these programs, and recent changes in federal law liberalizing their use in the wake of the pandemic.
On March 27, 2020, President Donald Trump signed the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act), Pub. Law No. 116-136, which provides for temporary withdrawals and loans of up to $100,000 and certain loan relief for affected participants. An affected participant is an individual:
⃞ Who is diagnosed with Covid-19 or SARS-CoV-2 by a CDC-approved test;
⃞ Whose spouse or dependent is diagnosed; or
⃞ Who experiences adverse financial consequences as a result of being quarantined, furloughed, laid off or having work hours reduced, who is unable to work due to a lack of child care, or having to close or reduce the hours of the individual's business.
See below for more information on CARES Act withdrawals and loans.
Section 401(k) plan loan programs comply with ERISA and tax code requirements when:
⃞ The loans are made in accordance with the specific provisions of the plan document, which must allow participants to borrow from their account balance.
⃞ The plan permits loans to all participants or beneficiaries on a reasonably equivalent basis.
⃞ The loans bear a reasonable rate of interest.
⃞ The loan must be repaid within five years (except if the loan is used to acquire a principal residence).
⃞ The loan is adequately secured.
⃞ The amount a participant may take as a loan is limited to the lesser of 50% of his or her vested account balance or $50,000.
Comment: Under the CARES Act, from March 27, 2020 through Sept. 23, 2020, affected participants may take loans up to the lesser of $100,000 or 100% of the participant's vested balance.
Review and Amend Plan Documents as Necessary to Permit Loans
Loans must be made in accordance with the specific provisions of the plan document, which must allow participants to borrow from their account balance. If the plan document doesn't already provide for plan loans (most 401(k) plans do) employer should amend the plan to permit them. Even if the plan document does permit loans, employers should consider whether to amend their plan to temporarily permit additional loans to accommodate the higher CARES Act loan limit.
Ensure All Loans Are Available on a Reasonably Equivalent Basis
Loans not made on a reasonably equivalent basis are a prohibited transaction under the tax code (I.R.C. 4975(d)(1)(A)).
⃞ Loans must be available to participants without regard to any individual's race, color, religion, sex, age or national origin.
⃞ Loans must not be unreasonably withheld based on facts and circumstances.
Comment: A loan program can generally exclude former employees and beneficiaries without violating the restriction against unreasonably withholding loans from any plan participant. In practice, most plans limit loans to actively employed participants for ease of administration and because former employees and beneficiaries are generally eligible to receive a distribution (DOL Opinion Letter No. 89-30A).
Charge a Reasonable Interest Rate
⃞ Participant loans that do not bear a reasonable interest rate are prohibited transactions under the tax code (I.R.C. 4975(d)(1)(D)).
⃞ The tax code does not mandate the use of any specific interest rate, but IRS rules require the interest rate to be “commercially reasonable.”
Comment: Some plan sponsors may wish to consider changing their loan interest rate given the current financial crisis, provided the new rate remains “commercially reasonable.” For example, sponsors with prime plus 2% may wish to change to prime plus 1%. Loan interest rates generally cannot be changed for existing loans, although an existing loan with a high interest rate (such as a primary residence loan) can be refinanced, subject to applicable limits.
Insist on Adequate Security for the Loan
⃞ A participant loan must have adequate security or it will be deemed a prohibited transaction (I.R.C. § 4975(d)(1)(E)).
⃞ A participant's vested account balance may be used as security for a participant loan.
Adequate security under DOL rules means that no more than 50% of a participant's vested account balance may be considered by a plan as security for a participant loan. Based on guidance issued after Hurricane Katrina, it appears that DOL will not challenge plans that offer CARES Act loans that exceed the 50% requirement. See IRS Notice 2005-92, footnote 3.
Enforce Repayment Terms
⃞ In general, the loan must be required to be repaid within five years (I.R.C. § 72(p)(2)(B)).
Comment: The CARES Act allows affected participants to defer repayment on existing loans for one year, although interest will continue to accrue.
⃞ A longer repayment period is permitted if the loan is used by the participant to acquire a principal residence.
Comment: Plan administrators should obtain documentation that a participant is eligible for a principal residence loan before the loan is approved. IRS audits have found that some plan administrators impermissibly allowed participants to self-certify their eligibility for a principal residence loan. Note that there is no required repayment period for a principal residence loan, but many plans use 10 or 15 years.
⃞ Repayments must be made in equal amounts at least quarterly. This is the so-called “level amortization” requirement under IRS rules.
⃞ Most participants make repayments through payroll deduction.
⃞ The plan document (or plan loan procedures) should specify the treatment of an outstanding loan when a participant terminates employment. On termination, plans may:
⃞ Require immediate repayment upon termination of employment; or
⃞ Allow the participant to continue to make loan repayments after a termination of employment.
Comment: If a plan sponsor wishes to allow participants to continue to make loan repayments after a termination of employment, it should ask its plan recordkeeper about payment options. Many recordkeepers allow repayment by Automated Clearing House (ACH) for terminated participants.
Many Section 401(k) plans allow an actively employed participant to make withdrawals from his or her vested account balance in the event of an immediate and heavy financial need, a type of withdrawal known as a “hardship withdrawal.”
Under IRS rules, hardship withdrawals are allowed when:
⃞ The plan document permits them.
⃞ The distribution is made only on account of an immediate and heavy financial need.
⃞ The distribution is necessary to satisfy that need, and only for an amount necessary to satisfy the need.
Examine Facts and Circumstances Supporting Immediate and Heavy Financial Need
Whether an employee has an immediate and heavy financial need is determined based on all the relevant facts and circumstances. Most plans use the “safe harbor” hardship events described below because it is easier to administer.
Safe Harbor Events Demonstrating Immediate and Heavy Financial Need
A hardship withdrawal is deemed to be made on account of an immediate and heavy financial need if the distribution is for these specific “safe harbor” events:
⃞ Payment of medical expenses;
⃞ Purchase of primary residence;
⃞ Payment of education expenses;
⃞ Prevention of eviction from principal residence, or foreclosure on the mortgage of that residence;
⃞ Payment of funeral expenses;
⃞ Certain repairs to a principal residence; and
⃞ Certain expenses and losses incurred as a result of a federally-declared disaster.
Comment: The IRS added the federally-declared disaster hardship event in the final hardship regulations issued on Sept. 30, 2019. Although the Covid-19 pandemic likely triggers the hardship withdrawal event in many states, the CARES Act temporary withdrawal is a more favorable option because, among other reasons, the CARES Act withdrawal is not subject to an additional 10% early withdrawal tax. CARES Act withdrawals to affected individuals of up to $100,000 may be made at any time before Dec. 31, 2020.
Confirm No Other Distributions Available and Obtain Employee Certification
A hardship withdrawal will not be considered necessary unless:
⃞ The employee has obtained all other currently available distributions under the plan and all other qualified or nonqualified plans maintained by the employer;
⃞ The employee has provided the plan administrator with a written representation (which can be made electronically) that he or she has insufficient cash or other liquid assets reasonably available to satisfy the need; and
⃞ The plan administrator does not have actual knowledge that is contrary to the employee's representation.
Comment: Prior to the Bipartisan Budget Act of 2018 (and the related final IRS hardship regulations), participants who took hardship distributions must first have taken a plan loan (if available) and were required to have their elective deferrals suspended for 6 months after the distribution. Effective Jan. 1, 2020, 401(k) plans are not permitted to suspend elective deferrals after a hardship distribution, but may continue to require participants to first take all available plan loans.
Permissible sources for hardship withdrawals include:
⃞ Elective deferrals, employer non-elective, matching, and safe harbor contributions.
⃞ Effective in 2019, earnings on 401(k) elective deferrals (2018 Bipartisan Budget Act, Pub. L. No. 115-123).
Any hardship withdrawal cannot exceed the amount necessary to satisfy the need, including federal, state, or local income taxes or penalties expected to result from the withdrawal.
Comment: Employers should check their plan to determine what sources are available for hardship withdrawals, and may consider expanding the available sources.
Certain events are considered safe harbors allowing for a hardship withdrawal provided the plan administrator has properly verified that the withdrawal is on account of such an event.
To substantiate a safe harbor hardship withdrawal:
⃞ Obtain “source documents” (for example, for a hardship distribution to cover medical expenses, the actual medical bills) to support a hardship distribution; or
⃞ Obtain a summary of the source documents from the participant (typically obtained through an online application process).
Under the summary method, the participant must retain the source documents, which can be requested in the event of an IRS audit. There are certain participant notice requirements, and the plan's recordkeeper must provide a report to the employer, at least annually, describing the hardship distributions made during the plan year.
Comment: Particularly during the global Covid-19 pandemic, the online summary substantiation method may be the easiest and fastest way for a participant to obtain a hardship distribution. Plan sponsors should check with their recordkeepers to determine whether this method is available. In considering this method, plan sponsors should be aware that they, not the recordkeeper, are ultimately responsible for ensuring the hardship verification process is consistent with IRS guidance.
Regular Hardship Withdrawals
⃞ A hardship withdrawal is a taxable distribution, and cannot be rolled over to an IRA or another qualified plan.
⃞ Under tax code Section 72(t), if a participant is under age 59-1/2, the hardship withdrawal is subject to an additional 10% income tax, unless certain limited exceptions apply.
⃞ A hardship withdrawal will be subject to 10% federal income tax withholding unless the participant opts for no withholding.
CARES Act Withdrawals
⃞ Like regular hardship withdrawals, a CARES Act withdrawal is a taxable distribution, and cannot be rolled over to an IRA or another qualified plan. However, the amount of any CARES Act withdrawal received in 2020 can be spread evenly over a three year period starting with 2020 on the participant's federal income tax return.
⃞ A CARES Act withdrawal is not subject to the additional 10% income tax under tax code Section 72(t).
⃞ A CARES Act withdrawal may be recontributed to an eligible retirement plan (including an IRA, qualified retirement plan, 403(a) annuity plan, 403(b) annuity contract, or a governmental 457(b) plan) within 3 years of receiving the withdrawal. Participants should consult with a tax advisor on the tax consequences of a recontribution.
⃞ Error: Failure to follow the plan's terms regarding hardship distributions.
⃞ How to Avoid: Ensure procedures are in place to review hardship applications.
During a plan audit, the IRS agent will look for documentation from the plan administrator to ensure that the plan made hardship distributions according to its terms and the law. Plan administrators (or participants, if the summary substantiation method is used) should obtain and maintain all documentation used to determine eligibility for a hardship.
In addition, the IRS often finds hardship distributions to participants where the plan allows for loans, but the participant does not have an outstanding loan. Note that if the plan no longer requires a participant to take a loan before taking a hardship distribution, as permitted under the IRS final hardship regulations, this should not be a concern. The IRS also finds hardship distributions from plans where the plan document does not allow for hardship distributions.
⃞ Error: Failure to follow the plan's loan provisions and violations of tax code Section 72(p).
⃞ How to Avoid: The IRS has noted common errors it finds during examinations regarding plan loans, which include:
⃞ Loans in excess of the $50,000 maximum allowed;
⃞ Incorrect treatment of outstanding loan balances when a participant terminates employment and the account balance is distributed;
⃞ Violation of plan provisions that limit the number of loans to a participant;
⃞ Loan terms longer than five years (even when not for the purchase of a primary residence); and
⃞ Plans that allow loans when the plan document does not allow loans.
Comment: In light of the global Covid-19 pandemic, it is expected that many participants experiencing financial hardship will seek to take loans or hardship withdrawals. Plan sponsors should review their plan documents to ensure that the plan provisions for loans and hardship distributions are consistent with plan operations and in-line with the sponsor's intent. For example, plan sponsors should consider whether they wish to allow access to a participant's entire account for hardship withdrawals, if plan document does not already permit this. Plan sponsors should also consider whether to offer CARES Act withdrawals and loans, which can be offered now, even though the plan is not required to be amended until the end of the 2022 plan year (2024 for governmental plans).