Ease the tax impact of natural disasters
Editor's note: This story originally ran Sept. 13, 1018. It has been updated.
Hurricane season is here, and clients in the path of a storm will have their hands full.
While IRAs and 401(k)s are for retirement, Congress knows that these accounts are sometimes the last resort for immediate disaster recovery and has often reacted quickly to provide tax relief for distributions from these plans. We’ll likely see this for Hurricane Michael, based on the relief provided for previous disasters.
Financial advisors can aide clients by being familiar with tax relief options that might be available to affected clients. Here’s what to look for.
First up: personal casualty losses, which were repealed under the Trump tax plan, but not for presidentially declared disaster areas. Clients in such areas may be able to claim a casualty loss deduction. Under current rules the deduction would have to exceed 10% of a client’s adjusted gross income and a $100 deductible (the same as under the old rules). The loss can be claimed on the 2017 tax return for more immediate relief.
Second: Congressional action. Based on prior relief granted, our senators and representatives may again come to the rescue and offer the same remedies they have in the past. Although not law yet, relief could include: penalty-free distributions from retirement plans and qualified hurricane distributions.
For an example, one needs only look to the “Disaster Tax Relief and Airport and Airway Extension Act of 2017” (the Act). The law included tax relief for victims of Hurricanes Harvey, Irma, and Maria. Its provisions were very similar to both the tax relief provided during Hurricane Katrina in 2005 and the relief proposed for victims of Hurricane Sandy in 2012 that never became law. They included several provisions that allow hurricane victims to tap retirement accounts easily and without some negative tax consequences.
Congress could copy these provisions for Hurricane Michael.
Here is how it worked in the past. A qualified hurricane distribution is a distribution made to an individual whose principal place of abode is in a hurricane disaster area and who has sustained an economic loss caused by the hurricane. (For a complete list of hurricane disaster areas, visit: https://www.fema.gov/disasters) An individual who has not sustained an economic loss will not qualify for tax relief under this legislation.
The maximum amount that an individual can take from all their retirement plans combined is $100,000 as a qualified hurricane distribution. A married couple could each take $100,000 from their own retirement plans. There are no restrictions on how the distributed funds are used, and the law does not specifically limit the amount of the distribution to the amount of the damage caused by the hurricane. A special provision in the law lifts the requirement that employer plans withhold 20% on rollover-eligible distributions so the individual will be able to receive the full amount distributed.
Storm victims who take qualified hurricane distributions also have the opportunity to repay a qualified hurricane distribution within three years to a retirement account tax free. The three-year period will begin on the day after the date the funds were received. Individuals can make one or more re-contributions during the three years. Repayments cannot exceed the amount that was distributed. The repayments can be made to any retirement plan to which the original distribution could have been rolled over.
They do not have to be made to the account which made the qualified hurricane distribution.
The repayments will be considered a direct rollover between a plan and an IRA and a trustee-to-trustee transfer between IRAs. This treatment means that no taxable event is considered to have happened when a repayment of a qualified hurricane distribution is done. It also means the once-per-year rollover rule will not apply to repayments of qualified hurricane distributions. If an individual has already paid income tax on their qualified hurricane distribution and then later re-contributes the funds to a retirement plan, they will be able to file an amended tax return to recover the taxes that they paid.
Spreading the income tax over 3 years
For many individuals already battered by storms, taking a sizeable taxable distribution from a retirement account could mean more grief, this time from Uncle Sam at tax time. Remember, even though a qualified hurricane distribution gets the individual out of the early distribution penalty, they will still have to pay income tax on any pre-tax funds they withdraw. To ease the pain, Congress has included a provision that allows individuals to include the income on their tax return ratably over a three-year period beginning with the year of the distribution. An individual can also elect to include the total amount in income for the year of the distribution.
Plan loan rules eased
To allow hurricane victims more access to funds in their employer plans, the Act increases plan loan limits for employees who live in hurricane disaster areas. The maximum cap on plan loans is increased to $100,000 for employees qualifying under current plan loan requirements. The loan must be made on or after September 29, 2017 and before January 1, 2019. The rule limiting loans to one half of the present value of the account has also been eased with affected individuals permitted to take the full present value of the non-forfeitable accrued account balance.
Plan loan payments can also be postponed. An employee with a principal place of abode in a hurricane disaster area with an outstanding plan loan is eligible for a one-year postponement of repayments. The repayments that can be postponed include those due on or after August 23, 2017 for those living in the Harvey disaster area, on or after September 4, 2017 for those living in the Irma disaster area, and September 16, 2017 for those in the Maria disaster area and include payments through December 31, 2018. The subsequent loan repayments will include the deferred payments and any interest that may have accrued during the deferral period. The five-year loan repayment schedule or term of the loan will also be adjusted.
Repayments of funds for home purchases
Under the Act, any individuals who took a retirement plan distribution to use in the purchase or construction of a home, and the purchase or construction is now cancelled due to Hurricanes Harvey, Irma, or Maria may be able to repay those funds to their retirement plan. This would include a distribution that qualified as a hardship withdrawal from a 401(k) or 403(b) plan or an IRA distribution that qualified for the first home purchase exception to the 10% early distribution penalty that was distributed after February 28, 2017 and before September 21, 2017 for the purchase or construction of a principle residence in a hurricane disaster area. These distributions can be recontributed tax-free by February 28, 2018.
Retroactive plan amendments
To cut through red tape and ease access to retirement funds, the Act allows affected employer plans and IRAs to operate under all the new rules as if the plan had been amended to allow these provisions. Plans have until the last day of the plan year beginning on or after January 1, 2019 to amend their plans. In effect, the plan will be amended retroactively.
Similar relief may be enacted quickly
Congress already has the blueprint for providing relief from what they enacted in the past so they should be able to have all of the above relief provisions available for Hurricane Michael.