Many of the proposed changes to the federal tax code that would have directly affected tax-qualified retirement plans were dropped from the final Tax Cuts and Jobs Act (TCJA) signed into law December 22, 2017. But a few of these dropped changes were incorporated into the Bipartisan Budget Act of 2018 enacted in early February this year (see related February story).

The Budget Act’s changes included easing some hardship distribution requirements and extending to victims of certain wildfire disasters the favorable distribution options that TCJA had given to hurricane victims.

As a result of these changes, many 401(k) plans may need plan amendments to either bring them into compliance with TCJA and the Budget Act, offer the distribution opportunities now permitted following this legislation, or comply with regulations implementing these provisions that have yet to be written. The deadline for adopting these amendments may not be until December 31, 2019, or later and some plans may not require amendments at all.

However, plan sponsors and administrators should not wait until 2019 to ensure they are complying with TCJA and the Budget Act.

Some of the tax-code changes in TCJA and the Budget Act will require all plan sponsors and administrators to evaluate their administrative procedures now, and possibly make changes to those procedures and ancillary documents, to ensure that their plans are administered in compliance with the plan document as well as the Internal Revenue Code as revised by the two acts. This article details three key areas that should be examined now.

Special Tax Notices

Code Section 402(f) requires plan sponsors to give written explanations of tax implications to recipients of qualified retirement plan distributions eligible for rollover treatment; these often are termed a “special tax notice.” The Internal Revenue Service (IRS) periodically has issued model special tax notices that meet the requirements of Code Section 402(f) as well as updates to those models to reflect changes in the law.

When the IRS issued its model special tax notice updated for the Pension Protection Act of 2006 (PPA), it stated in Notice 2009-68 that if “the law governing the tax treatment of distributions or other provisions described in a safe-harbor explanation in this notice is amended after September 28, 2009, the safe-harbor explanation will not satisfy §402(f) to the extent that the safe-harbor explanation no longer accurately describes the relevant law.”

As a result, plan administrators have since been on their own to update the special tax notice to ensure it remains accurate in between IRS updates. The IRS last updated the model special tax notices in Notice 2014-74 to incorporate changes in the law since 2009, but as of yet has not issued an update incorporating the Code changes made by TCJA.

The TCJA change extending the period for rollover plan loan offsets (see January story) will require updating the model IRS special tax notice. Many 401(k) plans that allow participants to take loans from their account balances contain an acceleration provision requiring all outstanding loan balances to be repaid at termination of employment. If not repaid, the loan balance will be defaulted, offset against the participant’s account balance, and deemed a taxable distribution includable in the participant’s income.

The plan is also required to withhold income tax, usually at a flat 20-percent rate, which is deducted from the participant’s account as well, and the withheld amount is also includable in the participant’s income for that tax year. The remaining account balance can be distributed to the participant and rolled over to an individual retirement account (IRA) or other qualified plan within 60 days (or directly rolled over in a trust-to-trust transfer).

Before TCJA took effect, participants who had outstanding loan balances defaulted and offset at termination had 60 days to come up with other funds equal to the outstanding loan balance, plus any amount of tax withholding, and roll those funds into an IRA or other qualified plan willing to accept them.

If the defaulted amount was not rolled over within 60 days (or a waiver of the 60-day requirement was not obtained from the IRS), the offset amount plus any tax withholding amount would be includable in the participant’s income for the tax year of the distribution. The amount also could be subject to the 10-percent early withdrawal penalty in Code Section 72(t) if the participant had not yet reached age 59 1/2 or met any other exception to the penalty.

TCJA modified the rollover distribution rules for participants who have experienced a 401(k) loan balance default and offset due to acceleration of the loan at termination of employment. Participants now have until the participant’s tax-filing deadline (usually April 15 of the following year, or October 15 if extended) to come up with the funds equal to the offset plus tax withholding and make the rollover.

In several places in the 2009 IRS model 402(f) special tax notice as modified by Notice 2014-74, references are made to the 60-day rollover requirement and consequences that flow from failing to make a rollover within that time. Because TCJA creates an exception to these consequences, the model special tax notice “no longer accurately describes the relevant law” and needs to be updated to avoid any inaccuracies or correct any statements that have now become misleading due to the new legislation.

Many plan administrators rely on their service providers to prepare and provide the special tax notice when processing distributions to participants. But under Code Section 402(f), the plan administrator is ultimately responsible for making the required special tax notice disclosure to the participant, and could face a potential breach of fiduciary duty suit under the Employee Retirement Income Security Act of 1974 (ERISA) to the extent a participant relied on any inaccurate or misleading statements.

Consequently, plan administrators should update their special tax notices or check with their service providers to ensure that the appropriate updates have been made.

Compensation Definition

It is always a good idea to periodically perform an internal self-audit of a 401(k) plan’s definition of compensation, to verify that the definition matches the administration in the plan sponsor’s payroll and reporting system and, consequently, the correct deferral and matching contributions are being made.

Compensation definitions specify remuneration elements that are either included or excluded when making contribution calculations. Improper treatment of various elements is a common operational error of 401(k) plan administration, and a common focus of both the IRS’s and U.S. Department of Labor’s (DOL) audit programs. If the plan documents and payroll system do not match, it can be a time-consuming and expensive error to correct. But in the wake of major tax reform legislation, a compensation self-audit can be vital to avoiding costly administrative errors and corrections.

The TCJA made several changes to the tax code that eliminated the ability for employers to deduct and employees to exclude from income certain fringe benefits received by the employee. For example, before 2018, the Code allowed an above-the-line deduction (meaning the amount is excluded from adjusted gross income rather than being an itemized deduction) for employees who incurred moving expenses.

The pre-2018 Code also allowed employers to reimburse employee-incurred moving expenses without including those amounts in the employee’s income. Beginning with the 2018 tax year through 2025, the deduction and exclusion for moving expenses is suspended under new Code Sections 132(g)(2) and 217(k).

Some 401(k) plans’ definitions of compensation distinguish between fringe benefits that are includable in or excludable from gross income, and will either be included or excluded from the plan’s definition of compensation depending on which tax category the fringe amount falls into. As a result, plan administrators will need to review their plan’s definition of compensation and may need to change the payroll system to reflect whether the moving expense element of remuneration is included or excluded for 401(k) plan purposes if it is no longer excludable from taxable income. Through this process, it is a good idea to check the other elements of remuneration identified in the compensation definition as well, and verify they are all properly coded in the employer’s payroll system.

Hardship Distributions

The Code allows 401(k) plans to make hardship distributions to participants who experience an immediate and heavy financial need. In the 401(k) regulations, the IRS has identified six circumstances, known as “safe harbor” hardships, that are deemed to meet the requirements of being an immediate and heavy financial need. Plan sponsors may allow hardship distributions for any of these six reasons without conducting an independent evaluation of whether such a need exists.

Plans also may allow hardship distributions for other reasons (if the plan document so provides), but the plan administrator must make an independent assessment that the reasons the participant cites are actually necessary to meet an immediate and heavy financial need. Some plan sponsors have decided not to undertake this analysis and limit hardship distributions exclusively to the six safe harbors.

In light of TCJA, however, plan sponsors that have limited their hardship distributions to the safe harbors now must change their hardship distribution processes for casualty-related home repair expenses, due to an indirect change in the Code.

Treasury Regulation Section 1.401(k)-1(d)(3)(iii)(B)(6) provides that a distribution is deemed to satisfy a participant’s immediate and heavy financial need if the distribution is for “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.”

TCJA did not directly amend the 401(k) hardship distribution options, but it did change Code Section 165 on which the home repair expense hardship safe harbor relies. The change limits the types of casualty losses that will meet that hardship safe harbor. (See April article.)

Before TCJA, Code Section 165 covered a wide range of casualty losses. Revisions to that Code section made by TCJA now limit casualty losses to those attributable to a presidentially declared disaster, such as a hurricane, flood, or wildfire. It is unclear if the effect to the casualty-related home repair safe-harbor hardship was deliberate, considered and accepted, or merely an unintended consequence of the broader tax reform policy goals of TCJA.

The real consequence of the enacted change, however, is that administrators of 401(k) plans that rely exclusively on the safe-harbor reasons for hardship distributions may no longer make those distributions for casualty-related home repair expenses that are not attributable to presidentially declared disasters. Plans could be amended to allow administrators to make non-safe-harbor hardship distributions, including for home repair expenses arising from casualties that are not presidentially declared disasters. But this provision would require the plan administrator to make an independent assessment of the facts and circumstances to determine if the participant has an immediate and heavy financial need.

Another aspect of the 401(k) hardship distribution regulation requires plans allowing these distributions to suspend participants who take a hardship distribution from making salary deferrals for 6 months after the distribution. As part of the hardship distribution revisions enacted in the Budget Act, Congress directed the IRS to remove this 6-month suspension requirement from the regulation.

The IRS may clarify the casualty-related home repair expense safe harbor when it revises the regulation as directed by Congress, or it may not. So far, regulators have been reticent in forecasting what the tax reform regulations may provide.

And speaking of removal of the 6-month suspension requirement, some plan sponsors have contemplated whether they can continue to keep this suspension requirement after the change mandated by the Budget Act becomes effective in 2019. Representatives from the IRS have reportedly opined at conferences that if a plan were to maintain a deferral suspension provision, it would be a benefit, right, or feature that must be tested to demonstrate that it did not impermissibly discriminate in favor of highly compensated employees (HCEs).

IRS personnel usually preface their comments at conferences by stating that their words are their own and they are not speaking on behalf of the IRS or the Treasury Department. Nevertheless, these comments provide some insight into how the IRS might view a plan that kept its 6-month suspension provision if it were no longer required under the regulation.

Action Required Now

As a result of all of these changes enacted by TCJA and the Budget Act, sponsors and administrators of 401(k) plans need to act now to ensure that their plans remain in compliance, even if the required deadline for adopting plan amendments may seem far off.