Change in Hardship Distribution Withholding Rules for 401(k) Plans

Under prior law, a hardship distribution from a Code Section 401(k) plan was an "eligible rollover distribution," subject to 20% mandatory withholding if it was not directly rolled over to another retirement plan or IRA. The Restructuring and Reform Act of 1998 ("RRA '98") changed the definition of an "eligible rollover distribution." Effective after December 31, 1998, hardship distributions made from salary deferral contributions are not eligible rollover distributions. In other words, hardship withdrawals from salary deferral accounts cannot be rolled over to another qualified plan or an IRA, and they are not subject to the mandatory 20% withholding rules. The IRS has given plan administrators an option to delay until January 1, 2000, the effective date of the change in the withholding rules.

RRA '98 does not affect the rollover treatment and withholding requirements applicable to hardship distributions from other accounts in a 401(k) plan, such as matching contributions and profit sharing contributions. Hardship distributions from matching accounts and profit sharing accounts remain subject to the eligible rollover distribution rules, including the mandatory 20% withholding requirement for amounts not directly rolled over. The bottom line is that a 401(k) plan's recordkeeping software and tax reporting system must be able to determine the source of the hardship distribution to correctly identify which portion, if any, is an eligible rollover distribution subject to mandatory 20% withholding if not rolled over.

To simplify administration of hardship distributions, plan sponsors can amend their plans to limit hardship distributions, either to 401(k) money or non-401(k) money. In any event, plan sponsors should consider when to implement RRA '98 hardship distribution rules and whether to amend their plans to limit the source of a hardship distribution.

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By the last day of the first plan year beginning on or after January 1, 2000, retirement plan sponsors must amend their plans for changes made by the Small Business Job Protection Act of 1996 ("SBJPA"), the Taxpayer Relief Act of 1997 ("TRA '97"), and for other recent changes in the law. Many changes instituted by SBJPA and TRA '97 are elective in the sense that a plan sponsor may choose when it will begin operating its plans in accordance with the changes or, in some cases, whether to implement the changes at all.

However, if a plan sponsor implements an elective provision in operation, the sponsor must amend its plan by the end of the plan amendment deadline to adopt the provision retroactive to the actual implementation date. For this reason, plan sponsors must keep accurate and detailed records describing how they are operating in accordance with each elective provision and when they began doing so.

The following examples illustrate some of the elective changes in the law that plan sponsors should track:

    1) TRA '97 allowed the cashout limit to be increased from $3,500 to $5,000 for plan years beginning after August 5, 1997, but did not require that plans adopt this provision. Plan sponsors may choose to continue to use a cashout limit of $3,500 or may increase that threshold to any amount that does not exceed $5,000. Accordingly, plan sponsors must document when and how they began operating their plans using an increased cashout limit.

    2) SBJPA included an elective provision in the new definition of "highly compensated employee." For plan years beginning after 1996, a plan sponsor, in determining which of its employees are highly compensated, has the option of making a top-paid group election. If a plan sponsor makes a top-paid group election for a plan year, then each employee who earned in excess of $80,000 during the preceding plan year and who was among the top 20% of employees when ranked on the basis of compensation is treated as a highly compensated employee. Plan sponsors must keep records showing whether they made a top-paid group election for any plan year after 1996.

    3) With regard to 401(k) plans, SBJPA permits plan sponsors to use current year contribution data or prior year data for non-highly compensated employees in performing ADP and ACP testing for plan years beginning after 1996. Plan sponsors must keep accurate records indicating which testing methodology was used for each plan year.

    4) SBJPA changed the minimum required distribution rules to allow plan participants (other than 5% owners) who attain the age of 70 ½ after 1995 to defer the distribution of their plan benefits until actual retirement. Plan sponsors must document whether they have applied the new rules in operation and, if so, how the new rules have been implemented.

If you would like more information on the upcoming plan amendment deadlines or your plan's operational compliance with elective changes in the law, please contact an attorney in Poyner & Spruill L.L.P.'s Employee Benefits Group.

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The IRS has finalized regulations under Code Section 79 that lower the tax cost of employer-provided group term life insurance, generally effective July 1, 1999. Code Section 79 provides that an employee may exclude from his or her gross income the value of the first $50,000 of employer-provided group term life insurance. The value of employer-provided coverage in excess of $50,000 is imputed taxable income to the employee.

Under the regulations, the IRS has adopted new, lower uniform premium rates that employers must use to calculate this value. The lower rates will reduce employees' taxable income, and will reduce FICA taxes for both employers and their employees.  The regulations reduce rates for all 5-year age brackets and create a new age bracket for employees under the age of 25. As a rule of administrative convenience, the regulations explain that employers do not need to modify current payroll systems by July 1, 1999, to take into account the new "under 25" age bracket and, until January 1, 2000, may use the new lower rate of $.06 per $1,000 of insurance protection for all employees under age 30.

The regulations further provide that, because imputed income under Section 79 is subject to FICA withholding, employers have two alternatives with respect to the overwithholding that would result from using the old rates. Employers that currently withhold FICA taxes on the imputed group term life insurance income each payroll period may continue calculating imputed income under the old rates and correct any resulting overwithholding no later than their final payroll period for 1999, or stop withholding on imputed group term life insurance income effective July 1, 1999, and treat all income imputed after this date as paid on December 31, 1999, making the appropriate FICA withholding at that time.

Certain group term life insurance plans under which employees pay the entire cost of coverage with after-tax contributions at a rate equal to or less than the rates specified in the regulations are not subject to the Section 79 imputed income rules. With respect to employee after-tax plans that were in existence on June 30, 1999, the regulations permit employers to use the current rates until January 1, 2003, for purposes of determining whether the plan continues to fall outside the imputed income rules.

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Effective January 1, 2001, a new law will require retirement plan administrators to withhold North Carolina income tax from many qualified retirement plan distributions. Although the North Carolina withholding obligations will be similar to current federal withholding obligations, there are significant differences.

Most plan administrators are accustomed to the federal withholding rules for plan distributions. Under these rules, plan sponsors are required to withhold federal income tax from most taxable distributions made from qualified retirement plans. Generally, the federal law requires different types of withholding for qualified periodic and non-periodic payments. Qualified periodic payments are qualified plan distributions made no less than annually in substantially equal amounts over a period of ten or more years. Periodic payments are subject to federal income tax withholding in accordance with applicable IRS wage withholding tables, as if those payments were wages. However, a recipient may elect not to have federal taxes withheld on periodic payments. Qualified non-periodic payments are qualified plan distributions that are eligible for rollover to another qualified plan or IRA, and are not paid as periodic payments over a period of ten or more years, such as a lump-sum distribution from a retirement plan. Qualified non-periodic payments are subject to a mandatory 20% withholding of federal income tax unless the distributions are directly rolled over to another qualified plan or IRA.

The North Carolina law will require North Carolina tax withholding in a manner similar to the federal requirements. Beginning in 2001, virtually any distribution that is not directly rolled over to another qualified plan or IRA will be subject to North Carolina income tax withholding under the new law. Periodic payments will be subject to withholding in accordance with North Carolina wage withholding requirements, as if the payments were wages. If a recipient of periodic payments fails to file an exemption certificate, withholding will be required as if the recipient were married and claiming three exemptions. All non-periodic distributions that are not directly rolled over to a qualified retirement plan or IRA will be subject to withholding of North Carolina income tax at the rate of 4%. However, unlike the federal withholding requirement, a recipient may elect not to have North Carolina income tax withholding apply to any qualified plan payments. In addition, a payor of qualified plan distributions is required to notify recipients of their right not to have withholding apply.

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