, Crain News Service
WASHINGTON -- The Internal Revenue Service is giving employers one more year to comply with a law designed to close a 401(k)/ IRA tax loophole that complicates plan administration.
Employers complained they didn't have enough time to modify their benefit administration systems to comply with the 1998 law, which was scheduled to take effect last week.
The law bars hardship withdrawal rollovers of pretax 401(k) contributions to individual retirement accounts. Using this technique, financially savvy employees can avoid a 10% penalty tax.
Under IRS Notice 99-5, employers in 1999 can allow employees to directly roll over to IRAs any 401(k) hardship withdrawals funded through pre-tax contributions. By Jan. 1, 2000, though, that practice will be barred.
Alternatively, employers can opt to comply immediately. However, employees at companies complying with the new law can -- for 1999 only -- make a hardship withdrawal and still avoid the 10% tax penalty by rolling over the funds to an IRA themselves. This must be done within 60 days of receiving the hardship distribution.
This option to take a one-year reprieve will be welcomed by employers that had faced only a few months in which to overhaul pension plan administration systems to comply with the new rules.
"This is really good news. When you have automated payment systems, you cannot just quickly turn these things on and off," said Frank Roque, a consultant with Hewitt Associates LLC in Lincolnshire, Ill.
"This is a very common sense approach," said Henry Saveth, an attorney with William M. Mercer Inc. in New York. "The IRS realized that some employers needed more time to make the necessary adjustments. At the same time, employers who have already made the changes will not have to undo something that already has been done."
Giving companies the choice of complying in 1999 or taking an additional year is an excellent compromise, said Rita Metras, director of total compensation at Eastman Kodak Co., Rochester, N.Y. "Some companies needed more time, while others did not," she said.
Others note the one-year relief notice would have been more helpful had it come out earlier. "There was a lot of scrambling," said Larry Heller, a director at PricewaterhouseCoopers, Fort Lee, N.J.
The issue originated in a 1997 law exempting some IRA distributions for the 10% withdrawal penalty, but not all. It didn't take long for employees to find a hardship distribution loophole.
First, an employee requests from his or her employer a hardship withdrawal from a 401(k) plan, but asks that the funds be directly rolled over to an IRA. After that, the employee withdraws the funds from the IRA and uses the money for a first-time home purchase or higher education expenses, which weren't exempt.
Congress got wind of this loophole and last year partially closed it. The IRS Restructuring And Reform Act of 1998 includes a provision saying pre-tax 401(k) salary deferrals no longer can be rolled over to an IRA; but it allowed employees to continue to withdraw other funds from their savings plans, such as employers' matching contributions, and roll over those funds to an IRA. These other withdrawals will continue to be exempt from the 10% early withdrawal penalty tax.
This wiggle room presents significant administrative hassles for employers: Under the new law, employers will have to tell employees that pretax contributions can't be rolled over under a hardship distribution to an IRA. At the same time, employers will have to explain that other savings plan funds can be rolled over to an IRA without penalty.
More importantly, automated 401(k) payment systems will have to be overhauled to accommodate the new environment.