TCJA causes glitch with hardship distributions

Glitches in the Tax Cuts and Jobs Act began bubbling to the surface almost the minute it was signed into law. Although there are higher priority items that need clarification and correction, one little-noticed provision may have an outsized impact on 401(k) plans that allow employees to take hardship distributions. If Congress doesn’t fix it, the glitch will remain in the tax code through 2025.

Personal casualty losses. The tax regulations set up a safe harbor under which employees may take hardship distributions from their 401(k) plans to repair their homes, if the repairs qualify as casualty losses under tax code Section 165.

Under the TCJA, casualty losses under Section 165 are limited to losses attributable to a disaster declared by the president. A hardship distribution to an employee whose house burned down, for example, can no longer be made.

Fixing hardship distribution errors. Hardship distributions that were made in error this year must be corrected. Employees must return the money. Plans that incorporate the safe harbor language must then be changed to conform to the TCJA. The IRS provides two options for making corrections:

  • Self-correction program: These errors are considered operational errors for which you can use the IRS’ self-correction program. This program is free, but limited to plans that have an established record of compliance.
  • Voluntary correction program: These errors also qualify for correction under the IRS’ voluntary correction program if your plan isn’t under audit. You may make a retroactive amendment that conforms to the TCJA. Participation in the VCP program isn’t free, though. Worse: The fees just went up. Beginning this year, fees range from $1,500 to $3,500 and the small plan exception no longer applies. Fees are now based on a plan’s net assets, rather than the number of participants.