The impact of Hurricane Katrina on residents of the United States' GulfCoast region has been felt in many areas of the survivors' lives, and it will continue to be felt in the foreseeable future. To assist survivors with the recovery process, the federal government has introduced a new act, signed into law in late September, that is intended to provide tax relief to those directly affected by the hurricane. Here we'll highlight some of the key provisions under the Katrina Emergency Tax Relief Act of 2005 (KETRA), as they relate to distributions and loans from qualified plans, 403(b) plans, governmental 457 plans and IRAs.
The Katrina Emergency Tax Relief Act of 2005 includes charity-giving incentives, work-related benefits for employers and employees, and the relaxation of some distribution and loan rules under retirement plans.
For you to understand KETRA and to know whether or not you qualify for relief, we need to define some terms first. They include the following:
- Hurricane Katrina Disaster Area: The Hurricane Katrina disaster area is defined as "an area with respect to which a major disaster has been declared by the President before September 14, 2005, under section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act by reason of Hurricane Katrina. The States for which such a disaster has been declared are Alabama, Florida, Louisiana, and Mississippi".
- Core Disaster Area: The core disaster area is defined as "that portion of the Hurricane Katrina disaster area determined by the President to warrant individual or individual and public assistance from the Federal Government under such Act".
- Qualified Hurricane Katrina Distribution: Under KETRA, certain penalties are waived and rules are relaxed for distributions that meet the definition of a qualified Hurricane Katrina distribution. A qualified Hurricane Katrina distribution is "a distribution from an eligible retirement plan made on or after August 25, 2005, and before January 1, 2007, to an individual whose principal place of abode on August 28, 2005, is located in the Hurricane Katrina disaster area and who has sustained an economic loss by reason of Hurricane Katrina. The total amount of qualified Hurricane Katrina distributions that an individual can receive from all plans, annuities, or IRAs is $100,000". Therefore, if you receive distributions in excess of $100,000, the excess amount will not be eligible for the benefits or relief provided under KETRA. Below we explain some of the more important retirement plan provisions under KETRA.
Waiver of the 10% Early-Distribution Excise Tax
Generally, an amount distributed from a qualified plan, a 403(b) account or an IRA before the participant reaches age 59.5 is subject to a 10% early-distribution excise tax, unless an exception applies. Under KETRA, amounts withdrawn are exempted from the excise tax if they are qualified Hurricane Katrina distributions.
Waiver of the 20% Mandatory-Withholding Tax
Rollover eligible amounts distributed from a qualified plan or 403(b) account or governmental 457 plans are subject to a mandatory withholding tax of 20%, unless the amount is processed as a direct rollover to an eligible retirement plan. Under KETRA, the 20% mandatory-withholding tax is waived for qualified Hurricane Katrina distributions. Be sure to provide any required documentation to your plan administrator so the withholding can be waived. Your plan administrator will determine what documentation is required to allow the waiver.
Income Spread Over Three Years
Distribution amounts from a retirement plan are usually treated as taxable income for the year the distribution occurs. Under KETRA, if the amount distributed is a qualified Hurricane Katrina distribution, the amount is included ratably in income over a three-year period, unless the individual elects not to have ratable inclusion apply. For instance, if the amount withdrawn is $30,000, $10,000 can be added to the individual's 2005, 2006 and 2007 income, unless the individual elects to include the entire amount as income for 2005.
Automatic Three-Year Extension of the 60-Day Rollover Period
Amounts that are withdrawn from a retirement plan and are rollover eligible can be rolled over to an eligible retirement plan within 60 days of the amount being received by the retirement account owner. However, the IRS has the authority to extend the 60-day period if failure to waive the requirement would be against equity or good conscience - this would apply to cases of casualty, disaster or other events beyond the reasonable control of the individual. (For more information, see Exceptions To The 60-Day Rollover Rule.)
Under KETRA, the 60-day period is automatically extended to a three-year period, if the distribution is a qualified Hurricane Katrina distribution. The three-year period begins the day after the taxpayer receives the distribution. The amount can be rolled over in a single sum or in multiple amounts, provided the aggregate amount rolled over does not exceed the distribution amount. In accordance with existing retirement plan rules, eligible Hurricane Katrina distributions that are properly rolled over are not subject to income tax or to the 10% early-distribution excise tax.
For example, let's say you received a distribution of $10,000 from your retirement account on Sept 30, 2005, and the amount is rollover eligible: you may roll over the amount to an eligible retirement plan any time up to Sept 29, 2007.
What if you included the amount in income before the rollover occurred?
If you included any portion of the amount in income and then rolled over the amount within the three-year period, you must file an amended tax return to claim the taxes you paid on the amount. An amended return must be filed for each year you included the amount in income.
Furthermore, if the amount was spread over a three-year period, and you rolled over the amount within the three-year period, you need not include the balance in your taxable income. The following examples illustrate the rules:
Assume you received a distribution of $45,000 from your retirement account in Sept 2005, and the amount is included in your income ratably over the next three years. You will be required to do the following:
Add $15,000 to your 2005 income
Add $15,000 to your 2006 income
Add $15,000 to your 2007 income
|Assumption # 1: Assume that in 2006 you rolled over the $45,000 to an eligible retirement plan. You would need to file an amended tax return for 2005 to claim the taxes you paid on the $15,000 you included in your 2005 income, and you must not include the scheduled $15,000 in either your 2006 income or your 2007 income.
Assumption # 2: Assume that in 2007 you rolled over the $45,000 to an eligible retirement plan. You would need to file amended tax returns for 2005 and 2006 to claim the taxes you paid on the $15,000 you included in your 2005 income and the $15,000 you included in your 2006 income, and you must not include the $15,000 in your 2007 income.
Qualified Distributions for Home Purchase May Be Rolled Over
To determine amounts that can be rolled over, if that amount was withdrawn for the purpose of purchasing or constructing a home, KETRA defines a qualified distribution as a hardship distribution from a 401(k) plan or a 403(b) annuity, or a qualified first-time homebuyer distribution from an IRA: (1) that is received after Feb 28, 2005 and before Aug 29, 2005; and (2) "that was to be used to purchase or construct a principal residence in the Hurricane Katrina disaster area". Generally, hardship distributions, including those from 401(k) and 403(b) plans, are not rollover eligible. And distributions from IRAs that were intended to be used for a first-time home purchase could be rolled over within 120 days, if eligible. Under KETRA, if the residence is not purchased or constructed on account of Hurricane Katrina, a qualified distribution amount may be rolled over to an eligible retirement plan that allows rollovers, from Aug 25, 2005 to Feb 28, 2006. The rollover amount will not be subject to income tax or the 10% early-distribution excise tax.
Modification of Loan Rules
A qualified plan participant may borrow up to 50% of his or her vested plan balance or $50,000, whichever is less. An exception may be made to allow participants to borrow up to $10,000, even if this exceeds the 50% limit, provided certain requirements are met. In addition, repayments must be made at least quarterly, must include level amortized amounts on interest and principal, and must be repaid within five years, unless the loan is used for the purchase of the participant's principal residence.
Under KETRA, the $50,000 limit is increased to $100,000 for qualified individuals, if the loan is made after Sept 23, 2005, but before Jan 1, 2007. In addition, repayments scheduled to be made for these loans during Aug 25, 2005 to Dec 31, 2006, will be delayed for one year, and the aforementioned amortization and five-year requirements will be considered satisfied. For this purpose, a qualified individual is an individual whose principal residence on Aug 28, 2005, was located in the Hurricane Katrina disaster area and who has sustained an economic loss as a result of Hurricane Katrina.
Before requesting a loan from your qualified plan account, be sure to take into consideration the repayments that you will be required to make, as well as the pros and cons of a qualified plan loan. Failure to make the repayments when they are due could result in a taxable distribution.
These are just the highlights of the relief provided under KETRA. Be sure to check with your tax professional for assistance in determining whether you are eligible for these and other forms of relief. If your distributions or loans qualify for the exceptions provided under KETRA, check with your plan administrator or IRA custodian to determine whether they require any special documentation, and be sure to keep detailed records for tax purposes. Many financial professionals recommend taking distributions and loans from your retirement plan only if you have no other financial resources and it is absolutely necessary. If you have access to financial planning services, be sure to check with your financial planner for assistance in making financially sound choices.