Spencer Fane LLP Logo

Tax Cuts and Jobs Act – New Rules for Retirement Plans and IRAs

Fourth in a Series

On December 22, 2017, President Trump signed into law major tax reform legislation (Public Law 115-97) known as the “Tax Cuts and Jobs Act,” or H.R. 1 (the “Act”).   Although the main feature of this legislation is a significant reduction in the corporate federal income tax rate, the Act also makes a number of significant changes to the tax treatment of employee benefits.

This is the fourth in a series of articles by which the Spencer Fane LLP Employee Benefits Practice Team will explain many of these key changes.  This article addresses the new rules governing employer-sponsored retirement plans and individual retirement accounts (“IRAs”).

Key Change #1

Participant Loans from Employer-Sponsored Retirement Plans

The Act reduces the potential tax burden on some participants who default on plan loans as a result of their termination of employment.  Participants who terminate employment with an outstanding loan from a Code Section 401(k) or other defined contribution plan often are immediately deemed to be in default on their loans. The consequence for such participants is that their loan is accelerated and “foreclosed” upon (i.e, the participant’s account balance is permanently reduced by the amount of the outstanding loan) in what is known as a “plan loan offset.”   Although under some plan loan policies the offset does not occur immediately (perhaps not for 30 or 60 days), once the offset occurs the participant has a limited period of time to roll the “plan loan offset amount” to an IRA or another employer plan in order to avoid having the unpaid loan amount treated as a taxable distribution.  (If the participant is under age 59 ½ at the time of the plan loan offset, he or she also could be subject to a 10% early withdrawal penalty.)  Under pre-Act law, participants had only 60 days to complete such a rollover.

For example, under pre-Act rules if a participant with a vested account balance (including the value of any outstanding loan) of $100,000 terminated employment when the balance of his or her outstanding loan was $20,000, and if the plan did not allow terminated participants to continue making loan repayments, the outstanding loan balance would generally be treated as due and payable at the time of termination (or very shortly thereafter).  If the loan was not repaid immediately, the outstanding balance would be offset against the participant’s account balance (i.e., the participant’s account would be reduced from $100,000 to $80,000).   If the participant then requested a distribution, he or she would only receive the $80,000 balance (if the distribution was paid as a direct rollover to an IRA or an eligible employer retirement plan).  The participant then would have only 60 days from the date of the loan offset to come up with the additional $20,000 from other sources and roll the $20,000 “loan offset amount” to an IRA or another employer plan.  If the loan offset amount was not rolled over within that 60-day period, it became a taxable distribution (which was also potentially subject to the 10% additional tax on early withdrawals).

The Act relaxes these rules by giving participants more time to roll over the loan offset amount.  A participant who incurs a “qualified” plan loan offset (i.e., a plan loan offset that occurs as a direct result of termination of employment, or the employer’s termination of the plan) after December 31, 2017, will have until the participant’s tax return due date (for the year in which the loan offset occurred) to roll over up to 100% of the plan loan offset amount into an IRA or another employer plan, and avoid paying federal income tax (and an early withdrawal penalty, if applicable) on the amount rolled over.   Although this is not a major change, it provides additional time for participants to come up with the money to repay an outstanding participant loan that would otherwise be treated as a taxable distribution solely because the participant terminated employment (and was not allowed, under the terms of the loan policy, to continue making loan payments after termination).    The additional time to roll over loan offset amounts also applies when the loan offset is directly related to the employer’s termination of the plan.  It does not apply, however, to any loan offset if the amount of the loan was previously treated as a “deemed distribution.”

Options for Employers

So what does this mean for plan sponsors?   For those whose plan loan policies only permit repayment by salary reduction (with no option to continue making payments after termination of employment), participants who terminate employment with an outstanding loan balance now will have additional time to come up with the funds to avoid having that loan balance become a taxable distribution.  Employers who currently allow former employees to continue making loan repayments after termination solely to avoid the harsh tax consequences of immediate loan offset may wish to reconsider their policy.  Such employers might consider eliminating the post-termination repayment option, now that participants will have additional time to roll over the loan offset amount and avoid a taxable distribution.

Either way, plan sponsors should review their written loan policies and the Section 402(f) “Special Tax Notices” (the notices that are provided to participants prior to receiving a distribution), to make sure that those documents accurately describe the tax consequences of terminating employment with an outstanding loan, and the new (longer) time frame for avoiding the unpaid loan being treated as a taxable distribution.

Employers may also wish to review the types of roll-ins their plans will accept in light of the new rules.  While some employers may choose to accept rollovers into the plan of amounts that a participant represents to be a timely rollover of a loan offset amount that occurred when the participant terminated employment with his or her previous employer, others may take the position that the additional time permitted for such rollovers adds an unwarranted complexity to rollover administration.


Hardship Withdrawals from 401(k) or 403(b) Plans Based on Damage to the Participant’s Personal Residence

The Act narrows the casualty loss deduction under Section 165 of the Code to losses attributable to disasters declared by the President under Section 401 of the Robert. T. Stafford Disaster Relief and Emergency Assistance Act.    This in effect “narrows” the hardship withdrawals that participants can take from 401(k) or 403(b) plans that use the “safe-harbor” hardship withdrawal rules.

Under those safe-harbor rules, the distribution must be on account of one of six “safe-harbor” categories of need (such as medical expenses or the costs related to the purchase of the participant’s principal residence).   One of those six categories of need is defined as “expenses for the repair of damage to the employee’s principal residence that would qualify for the casualty deduction under Section 165, determined without regard to whether the loss exceeds 10% of adjusted gross income.”    Prior to the Act, an expense related to any type of damage to the employee’s principal residence would qualify for this safe harbor.  For taxable years between 2018 and 2025, however, the Act limits this safe harbor to expenses related to damage to the employee’s principal residence that is attributable to a disaster declared by the President.


Employers (and/or their service providers) will need to modify their criteria for approving “safe-harbor” hardship distributions that are made to reimburse expenses for damage to the employee’s principal residence.    Plan sponsors may also wish to incorporate this limitation in the Summary Plan Description or other plan materials that describe the rules for hardship distributions.


Other Changes Affecting Retirement Plans

The Act provides various types of tax relief for 2016 and 2017 distributions from eligible employer plans (and IRAs) due to 2016 storms and flooding.  The relief granted is similar to, but not as extensive as, the recent Congressional relief for Hurricanes Harvey, Irma and Maria.   Under the Act, distributions made in 2016 and 2017 that constitute “qualified 2016 disaster distributions” are eligible for a variety of special tax rules, including relief from the 10% early distribution tax and the ability to spread the tax on the distribution pro-rata over a three year period.  This relief is retroactively effective as of the Act’s date of enactment (December 22, 2017).

The Act also doubles the benefit accrual permitted for special volunteer public safety programs under Code Section 457(e)(11).  Under pre-Act law, certain volunteer plans for public safety employees could avoid the restrictions of Code Section 457 so long as accruals for “length of service awards” under the plan did not exceed $3,000 per year.   The Act replaces the $3,000 cap with a $6,000 cap, which is indexed for years after 2018.  Employers that offer these programs may wish to amend their plans to increase permissible benefits in order to take advantage of this new rule.

Recharacterization of Roth IRAs

Under pre-Act tax law, the recharacterization rules generally allowed individual taxpayers to “undo” or “change the character of” certain types of IRA transactions, so long as the necessary action was taken by the tax return due date, including extensions, for the year of the original transaction.   For example, prior to 2018, taxpayers could recharacterize:

  1. A “regular” Traditional IRA contribution as a “regular” Roth IRA contribution (if the Roth income limitations were satisfied);
  2. A “regular” Roth IRA contribution as a “regular” Traditional IRA contribution;
  3. A “conversion” (of Traditional or SIMPLE IRA assets to Roth IRA assets) back to the original type of IRA; or
  4. A “retirement plan-to-Roth IRA” rollover as a rollover to a Traditional IRA.

It should be noted that even prior to the Act, “in-plan” conversions (of non-Roth contributions to “designated Roth contributions” within a 401(k), 403(b) or governmental 457(b) plan) could not be recharacterized as non-Roth amounts.

Under the Act, the recharacterizations described in items 3 and 4, above, are no longer permissible.  Effective January 1, 2018, any amounts that are “converted” (in a taxable conversion) from non-Roth amounts to Roth amounts (whether by conversion of a Traditional IRA to a Roth IRA, a retirement plan-to-Roth IRA rollover, or an “in-plan conversion”) cannot be “recharacterized” as Traditional IRA (or “non-Roth”) amounts.

The Act does not change the recharacterizations described in items 1 and 2, above.  Therefore, an amount that is “contributed” to a Roth IRA (i.e., amounts up to $6,500 that are made as a “regular” Roth IRA contribution) may still be “recharacterized” as a contribution to a Traditional IRA, if the amount is properly transferred by the taxpayer’s tax return due date, including extensions, for the year of the original Roth IRA contribution.  Likewise, amounts of up to $6,500 per year that are contributed to a Traditional IRA may still be “recharacterized” as Roth IRA contributions (if the taxpayer qualifies for such contributions), if the transfer is made by the due date, including extensions, of the tax return for the year of the original Traditional IRA contribution.

On January 18, 2018, the IRS updated its Frequently Asked Questions regarding Roth recharacterizations.  The last question in those updated FAQs confirms that the new law applies solely to “conversions” made on or after January 1, 2018.  Therefore, a Roth IRA conversion that was made in 2017 still may be recharacterized as a traditional IRA if the recharacterization is completed by October 15, 2018.

If you have any questions about how these new rules affect your company’s retirement plans (or your employees’ IRAs), please contact any of the attorneys in Spencer Fane’s Employee Benefits Practice Group.

View the other articles in the Tax Cuts and Jobs Act series here.

This blog post was drafted by Robert Browning, an attorney in the Spencer Fane LLP Overland Park, KS office. For more information, visit spencerfane.com.