The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) generally allows parents to take an early distribution (up to $5,000) from an employer sponsored retirement plan or IRA during the 12-month period beginning on the date a child is born or legally adopted. The distribution is not subject to the 10% additional income tax for early withdrawals (generally, distributions made prior to attainment of age 59 ½). In addition, the new law permits repayment of such distributions (which are treated as rollover contributions) to an employer sponsored plan or IRA. The new law is effective for distributions made after December 31, 2019.
This new law, however, leaves several unanswered questions regarding these types of distributions – particularly, the permissible timeframe for “repaying” such a distribution to an eligible retirement plan. The IRS did issue preliminary guidance in Notice 2020-68, addressing some of the provisions of the law, but regulations will ultimately need to be issued before it is clear how all of the provisions will apply.
How does the new law define “qualified birth or adoption” (QBA) distributions?
A QBA distribution is defined as any distribution made from an eligible retirement plan to an individual during the one-year period beginning on the date a child was born or legally adopted. Note that legal adoption of a child under the age of 18 or a disabled individual (as defined under IRC section 72(m)(7)) would qualify provided the child (or disabled person) is not the individual’s stepchild.
What types of retirement plans can allow QBA distributions?
Eligible retirement plans include defined contribution plans, e.g., 401(k) plans, 403(b) plans, governmental 457(b) plans, and IRAs.
Are plans required to offer this distribution option?
No. This is an optional provision, not a required one. Based on the preliminary guidance in Notice 2020-68, however, if a plan permits QBA distributions, the plan will also be required to permit repayment of such distributions (up to the amount distributed from the plan) if the participant would otherwise be eligible to make a rollover contribution.
Is this a new type of hardship distribution?
No. It is an entirely new type of in-service distribution. It is permissible to make QBA distributions from restricted accounts (e.g., 401(k), Roth, and safe harbor accounts), and unlike hardship distributions, QBA distributions may not be “grossed up” for income taxes, and there is no requirement that a participant demonstrate a financial need or even how the funds will be used. Rather, the only requirement is that the participant has had a child (or adopted a child or disabled person) within the last 12 months. Notice 2020-68 states that the plan administrator can rely on the participant’s representation that he or she qualifies for a QBA distribution, unless the plan administrator has specific knowledge to the contrary.
Are there limits that apply to QBA distributions?
Yes. There is an individual and plan limit. The individual limit that applies to each parent, i.e., there is not a “family” limit. Additionally, the $5,000 individual limit is determined separately for each child. For example, assume a couple has twins. Each parent could withdraw up to $10,000 ($5,000 x two children) from his or her eligible retirement plan accounts.
With respect to QBA distributions made from plans, the $5,000/per child limit applies to all plans maintained by the employer, e.g., all plans sponsored by a controlled group. As a result, plan administrators must limit the amount distributed under the new rules to the maximum an individual could receive (taking into consideration all plans sponsored by the employer). Plan administrators are not, however, required to determine whether the participant would qualify for the QBA distribution based on QBA distributions made from other plans (sponsored by unrelated employers), or the individual’s IRA(s). The participant (or IRA owner) is ultimately responsible for reporting QBA distributions on their individual income tax return.
If a plan permits QBA distributions, what are the withholding and reporting requirements?
QBA distributions are not treated as eligible rollover distributions for purposes of the special tax notice (required under IRC section 402(f)) or the withholding rules (which generally require 20% federal withholding on eligible rollover distributions). Rather, they are subject to a 10% default withholding rate for federal income taxes, unless elected otherwise by the participant.
The Form 1099-R instructions have been updated for QBA distributions and indicate that such a distribution generally should be reported as a taxable distribution, using Code 1 (early distribution, no known exception). This is presumably because the plan administrator would have no way of knowing whether the distribution made from the plan would ultimately qualify since all QBA distributions taken by the individual (which would include distributions made from other plans and IRAs) must be considered.
Also, in order for the distribution to qualify as a QBA distribution, the participant must report the name, age, and taxpayer identification number of the child (or disabled person) on his or her individual income tax return.
If a plan does not permit QBA distributions, and a participant is otherwise eligible for a distribution, can they treat the distribution as a QBA distribution?
Yes, to the extent it does not exceed the individual’s limit, i.e., $5,000 per child. Keep in mind, the plan would process the distribution without regard to how the participant handles it on their income tax return. For example, a plan could not waive mandatory 20% federal withholding (at the participant’s request) if a participant indicates they will be treating the distribution as a QBA distribution on their personal income tax return.
How can a participant repay a QBA distribution?
First, as mentioned above, the law did not provide the timeframe for repaying such distributions, so the regulations will need to be issued before the rules are clear (or rather, hopefully clear). Presumably, there may be a requirement that the distribution be repaid within three years (similar to disaster and coronavirus-related distributions) since an individual’s income tax return is generally “open” for three years.
If a plan permits QBA distributions, the plan must also permit repayment of those distributions (up to the amount distributed from the same plan), provided the participant would otherwise be eligible to make rollover contributions to the plan at the time of the repayment. For example, most 401(k) plans do not allow terminated participants to make rollover contributions, so a terminated participant generally would not be allowed to repay a QBA distribution to the distributing plan. If the participant is not eligible to make a rollover contribution to the distributing plan, it would appear they will be able to repay the amount to an IRA, though.
Further, it may be that such repayments are treated in the same manner as disaster and coronavirus-related distributions, meaning that an individual will be able to use Form 8915 series to report the repayment and claim the deduction. Again, the IRS will need to issue regulations (and possibly other guidance) to address the repayment rules for QBA distributions.
If a plan sponsor wants to permit QBA distributions, what actions must be taken?
A plan can permit QBA distributions now, as long as the plan adopts the conforming amendment by the deadline provided under the SECURE Act, i.e., December 31, 2022 for calendar year plans. Note that collectively bargained and governmental plans generally have until the last day of the 2024 to adopt the conforming amendment.
How can I learn more about the new rules?
When the IRS issues the regulations (or other guidance), we will provide an update. In the interim, please contact EJReynolds to learn more about these rules and how they may impact your plan and plan participants.