Hardship Distribution Changes – Tax Reform May Have Unintended Consequences

When tax reform proposals were floating around in the fall of 2017, several early proposals to the Tax Cuts and Jobs Act (the “Act”) included changes to the hardship distribution rules for qualified retirement plans. However, the final version of the Act did not make any direct changes to hardship distributions.  Nevertheless, the Act, perhaps unintentionally, made a significant change to the circumstances under which a participant can request a hardship for a personal casualty loss.

Personal Casualty Loss

The Act changed to the definition of a “personal casualty loss” under Section 165 of the Internal Revenue Code (the “Code”). Under the revised definition of 165, a personal casualty loss is only deductible if it is attributable to a federally declared disaster (i.e., a disaster that is declared by the President under the Robert T. Stafford Disaster Relief and Emergency Assistance Act).  Most 401(k) and 403(b) plans use the “safe harbor” standards for approving hardship distributions.  The safe harbor standards permit hardship distributions for a “personal casualty loss,” which is defined as damage to the employee’s principal residence that would qualify for the casualty deduction under Code Section 165.  In light of the changes made by the Act, the availability of a hardship distribution for a personal casualty loss will be limited only to damage to a participant’s principal residence that occurs in a federally declared disaster.

Unintended Consequence?

It is not entirely clear whether this change to hardship distributions was intended under the Act. The IRS may decide to address this issue in subsequent guidance, but until further guidance is issued, plans may wish to comply with the hardship distribution provisions as modified by the Act.  The new definition is applicable to casualty losses that occur in tax years beginning after December 31, 2017 and before January 1, 2026.