4036 / What prohibited distribution requirements apply to tax-sheltered annuity plans?

A custodial account invested in mutual funds must provide that amounts will not be made available before the employee dies, attains age 59½, has a severance from employment, becomes disabled within the meaning of IRC Section 72(m)(7), encounters financial hardship or except as may be otherwise provided by regulations, with respect to amounts invested in a lifetime income investment (i) on or after the date that is 90 days prior to the date that such lifetime income investment may no longer be held as an investment option under the contract, and (ii) in the form of a qualified distribution (as defined in section 401(a)(38)(B)(i)) or a qualified plan distribution annuity contract (as defined in section 401(a)(38)(B)(iv)).¹

Hardship withdrawals may be made only on account of an immediate and heavy financial need ( Q 3798). In years beginning after December 31, 1988, financial hardship distributions may be made only from assets held as of the close of the last year beginning before 1989 and from amounts contributed thereafter under a salary reduction agreement, not including earnings on these amounts.

An annuity contract must provide that distributions attributable to salary reduction contributions, including the earnings on them, may be made only after the employee attains age 59½, has severance from employment, dies, becomes disabled, or in the case of hardship, except that the earnings on salary reduction contributions may not be distributed for financial hardship, or, for tax years beginning after 2020, with respect to amounts invested in a lifetime income investment (i) on or after the date that is 90 days prior to the date that such lifetime income investment may no longer be held as an investment option under the contract, and (ii) in the form of a qualified distribution or a qualified plan distribution annuity contract.² These restrictions apply for years beginning after 1988, but only with respect to distributions attributable to assets other than assets held as of the close of the last year beginning before 1989.³ Assets held prior to that date are not subject to these restrictions.

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Planning Point: The Bipartisan Budget Act of 2018 removed the restriction on distributing earnings as hardship distributions beginning in 2019 (although the changes remain optional for plan sponsors) for qualified plans. Despite this, it remained unclear whether the new rules will apply to 403(b) plans because of the way the statute itself is drafted. The Section 403(b) regulations (as well as Section 403(b) itself) clearly prohibit the distribution of earnings as hardship distributions.⁴ Late in 2022, Congress passed the “SECURE Act 2.0,” which clarified that the newly expanded rules do apply equally to 403(b) plans. 403(b) plans may thus allow distributions of qualified non-elective contributions, including earnings, qualified matching contributions, including earnings and earnings on elective deferrals. Participants will no longer be required to take all available plan loans before they are able to take a hardship distribution under the new rules.  The expanded hardship distribution rules will only apply if the plan itself decides to amend the terms of the plan document. The new rules are effective for plan years beginning after
December 31, 2023.

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Timely distributions of excess elective deferrals ( Q 4047) and excess aggregate contributions ( Q 4038) may be made without regard to the above restrictions,⁵ as they are amounts not attributable to salary reductions that are held in an annuity contract. For the restrictions affecting retirement income accounts, see Q 4052.

Amounts borrowed from a tax sheltered annuity and treated as a deemed distribution under IRC Section 72(p) ( Q 4063) are not treated as actual distributions for purposes of these distribution restrictions and will not violate these restrictions.⁶ If a participant’s accrued benefit is reduced or offset to repay a loan, an actual distribution occurs for purposes of these distribution restrictions.⁷ Accordingly, a plan may be prohibited from making such an offset to enforce its security interest in a participant’s account balance attributable to salary reduction contributions until a date on which a distribution is permitted under IRC Section 403(b)(11).⁸

Similarly, it would seem that servicing a plan loan with tax sheltered annuity funds before a distribution is permitted would constitute a prohibited distribution. Even though a distribution may be permitted under these rules for hardship or after severance from employment, it may nonetheless be subject to a 10 percent tax in addition to income tax as a premature distribution ( Q 4074). These rules also apply to custodial accounts.

A distribution to a former spouse pursuant to a qualified domestic relations order (“QDRO”) will be permitted under certain circumstances ( Q 3915) even though the distribution otherwise might be prohibited under the prohibited distribution rules.⁹