The Setting Up Every Community for Retirement Enhancement Act (the “SECURE Act”), subsumed in the Further Consolidated Appropriations Act of 2020 and signed into law by President Trump in December 2019, effectuated a myriad of changes to qualified retirement plans. One of the more significant provisions in the SECURE Act includes the expansion of the exceptions to the 10 percent early withdrawal tax in the event of a qualified birth or adoption distribution of up to $5,000.
Previous and Updated 401(k) Eligibility Provisions
Code Section 72(t) imposes a 10 percent early withdrawal tax on distributions from qualified retirement plans unless one of the following exceptions applies:
- Distribution is made on or after the date in which the employee attains age 59 1⁄2;
- Distribution is made to a beneficiary on or after the death of the employee;
- Distribution is attributable to the employee being disabled (as defined under Code Section 72(m)(7);
- Distribution is part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of such employee and his designated beneficiary;
- Distribution is made to an employee after separation from service and attainment of age 55;
- Distribution is dividends paid with respect to stock of a corporation which are described in section 404(k);
- Distribution is made on account of a levy on the qualified retirement plan; or
- Distribution is part of a payment under a phased retirement annuity or a composite retirement annuity under Code Sections 8366 or 8412.
On September 2, 2020, the IRS issued Notice 2020-68 (the “Notice”) that provides additional “gloss” to the new ten percent early withdrawal tax exception for qualified birth or adoption distributions of up to $5,000. The expansion applies to qualified retirement plans, including 403 and 457 plans and IRAs. A qualified birth or adoption distribution is still includible in income, but it is not subject to the 10 percent early withdrawal tax.
Definition, Documentation and Recontribution
A qualified birth or adoption distribution includes any distribution from an eligible retirement plan to an individual made within the 1-year period beginning on the date on which the child is born or the legal adoption is finalized. Notably, an eligible adoptee for these purposes does not include the child of the requesting individual’s spouse. Plan administrators may rely upon a reasonable representation from an individual that he or she is eligible for a qualified birth or adoption distribution (so long as the plan administrator doesn’t have actual knowledge to the contrary) instead of requiring a copy of a birth or adoption certificate to verify eligibility. An individual may recontribute a qualified birth or adoption distribution to an applicable eligible retirement plan in which the individual is a beneficiary and to which rollovers can be made. However, a qualified birth or adoption distribution is not treated as an eligible rollover distribution for purposes of the direct rollover rules and the 402(f) notice requirement (see our recent article, IRS Provides Updated Model 402(f) Notices – For SECURE Act Changes That Do Not Necessitate a 402(f) Notice (!)).
Pursuant to the Notice, the Treasury Department and IRS intended to release regulations that provide additional guidance regarding the recontribution rules (including recontribution timing rules). The Notice clarifies that if a retirement plan is amended to allow qualified birth or adoption distributions, the plan is required to accept recontributions if the individual received such a distribution from that plan and the individual is eligible to make a rollover distribution to that plan at the time of recontribution. This suggests that an employee who receives a qualified birth or adoption distribution and then separates from service will not be able to make a recontribution to that plan. Presumably, however, these individuals would be able to recontribute the amount to an IRA.
- A distribution will not be treated as a qualified birth or adoption distribution with respect to any child or adoptee unless the individual includes the name, age, and TIN of the child or adoptee on the individual’s tax return for the taxable year in which the distribution is made.
- The new qualified birth or adoption distribution is optional, and a plan may decide not to adopt this distribution option.
- An eligible adoptee does not include an individual who is the child of the taxpayer’s spouse.
- If a retirement plan does not adopt the qualified birth or adoption distribution, an individual may choose to treat an otherwise permissible in-service distribution as a qualified birth or adoption distribution on his or her federal tax return if it otherwise meets the requirements of a qualified birth or adoption distribution. In addition, the individual would be able to recontribute the amount to an IRA if the individual is a beneficiary of that IRA and is eligible to make rollover contributions to the IRA at that time.
Qualified Distribution Limits Apply on a Per Parent, Per Child Basis
Pursuant to the Notice, each parent may receive a qualified birth or adoption distribution of up to $5,000 with respect to the same child. An individual may also receive qualified birth or adoption distributions with respect to the birth or adoption of more than one child or adoptee if the distributions are made during the one-year period following the date on which the children are born or legally adopted.
Example: Spouses A and B have triplets on November 1, 2020. Both spouses’ employer- sponsored 401(k) plans allow for the qualified birth or adoption distribution. Spouses A and B are therefore eligible to withdraw, penalty-free but not tax-free, up to $15,000 each for a total of $30,000, provided that they apply for the distribution before November 1, 2021.
Deadline for Plan Amendment
The deadline for a plan sponsor to adopt the SECURE Act qualified birth or adoption distribution depends upon the type of plan being amended. The amendment deadline for a qualified plan that is not a governmental plan and a 403(b) plan that is not maintained by a public school is the last day of the plan year beginning on or after January 1, 2022. In comparison, a governmental qualified plan, a 403(b) plan maintained by a public school, or a 457 plan generally has until the last day of the plan year beginning on or after January 1, 2024. If a plan decides to allow a qualified birth or adoption distribution after the 2022 plan year, then the plan must be amended by the last day of the plan year in which the distribution is added.
Plan sponsors should carefully consider whether adding a qualified birth or adoption distribution option is appropriate and desired for their retirement plans, particularly since, once added, the new in-service distribution option would be a protected benefit (i.e., this distribution option cannot be retroactively eliminated from the plan). If, for example, further IRS guidance regarding recontribution mechanics results in administratively impracticable requirements, the distribution option could only be prospectively eliminated, and prior distributions would still be required to comply with that new guidance. Unlike other mandatory SECURE Act changes (such as changes to Long-Term, Part-Time Workers as we discussed in our recent article, IRS Provides SECURity Through 401(k) Plan Expansion to Long-Term, Part Time Workers), employers have some time to consider this distribution and to await further guidance regarding recontribution rules. If an employer chooses to adopt this new distribution option, the employer should ensure that the retirement plan is timely amended and that procedures are in place, both internally and with any outside third-party service providers, to process these claims.