Natural Disasters Damage Retirement Accounts, Too

What options do participants have when a natural disaster affects them, and are there steps plan sponsors can take to reduce the impact on retirement savings?

Natural disasters are known to damage communities and properties. Less understood, however, is the harm they can cause to participant retirement accounts.

When a participant’s home or property is destroyed, dipping into his defined contribution (DC) plan account may be one of the first actions he takes. This leads to early distribution taxes and penalties and cuts savings accumulated. And, because participants will take a period of interrupted employment to work on their homes and communities, this makes a dent into their retirement account as well since retirement contributions are disturbed too, says Steve Friedman, a shareholder who advises employers on employee benefits law at Littler Mendelson.

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“If somebody has a home that is damaged, it certainly opens up the prospect of that person needing some money to get themselves financially through,” he says. “That gets into the question of what rules govern their access to 401(k) or 403(b) assets.”

Earlier this year, the Department of Labor (DOL) provided guidance to employee benefit plans, plan sponsors and workers affected by severe storms in Nebraska, Iowa and Alabama, and in June, Congress added a special tax relief to the newly-signed Disaster Relief Bill. This relief granted access to the retirement funds of those affected by federally declared disasters in 2016 and 2017, and allowed these participants to repay distributions within three years, avoid additional early distribution taxes, borrow supplementary funds as a plan loan, and more.

More recently, the IRS has amended hardship withdrawal rules modifying the safe harbor list of expenses in the Internal Revenue Code for which distributions are deemed to be made on account of an immediate and heavy financial need by adding a new type of expense to the list, relating to expenses incurred as a result of certain disasters. The IRS says this is “intended to eliminate any delay or uncertainty concerning access to plan funds following a disaster that occurs in an area designated by the Federal Emergency Management Agency (FEMA) for individual assistance.”

However, it’s important to note that while afflicted participants may take hardship withdrawals, that is only the case if the plan allows for hardship withdrawals. Employers are not required to offer hardship withdrawals in their plan.

“Any type of hardship withdrawal has to be pursuant to the retirement plan,” says Wesley Stockard, co-chair of the Employee Retirement Income Security Act (ERISA) and Benefit Plan Litigation team at Littler Mendelson. “These are not a benefit that must be provided, an employer has to have them as a provision that employees can take advantage of.”

“Employees need to keep in mind that though there has been a terrible circumstance, there is still a process that needs to be gone through,” he adds. “Doing this process correctly protects the employer and employee from any accusations.”

Friedman and Stockard recommend employees consult the summary plan description (SPD) should they have any questions regarding plan benefits. An SPD acts as a basic ERISA disclosure document for employees to understand. Following these steps ensures compliance for both employers and participants, especially in times of natural disasters where there is increased urgency.

IRS hardship withdrawal rules were amended in a way that could help reduce the impact on retirement savings from having to take a hardship withdrawal. Six-month bans placed on 401(k) or 403(b) contributions of participants taking a hardship distribution no longer not apply. Employees do not have to take a loan first, although plan sponsors may still require that, and the IRS has made it easy for participants to provide proof of their financial need.

A guide published by Fidelity examines the topic of retirement plan hardship withdrawals, with the objective of improving the long-term financial health of those who take them. Fidelity reminds plan sponsors that they still have discretion over limiting the amount of hardship withdrawals, and it recommends helping participants establish emergency savings to avoid having to take a distribution.

If participants choose to take a plan loan instead, they need to understand the differences from taking a hardship withdrawal. While plan loans are not subject to penalties since employees are borrowing the money, if a participant leaves his employer before paying off the loan, he is still required to pay the residual balance.

An analysis from Deloitte finds that more than $2 trillion in potential future account balances will be lost due to loan defaults from 401(k) accounts over the next 10 years. This figure includes the cumulative effect of loan defaults upon retirement, including taxes, early withdrawal penalties, lost earnings, and any early cashout of defaulting participants’ full plan balances. For a typical defaulting borrower, this represents approximately $300,000 in lost retirement savings over a career.

It recommends plan sponsors establish and enforce robust education and loan risk awareness programs designed and curated for fiduciary responsibility, prior to lending approval. Plan sponsors may also reduce the permissible loan amounts and number of loans outstanding per participant, and increase flexibility in payback timelines, as well as enforce waiting periods for plans that are currently designed to allow participants to take multiple loans.

Deloitte points out that the DOL states that loan programs should not diminish a borrower’s retirement income or cause loss to the plan, and views loans as investments, requiring the same fiduciary oversight as any other plan investment option.