Hardship Distribution Changes

The SECURE Act now allows penalty-free withdrawals to cover expenses related to the birth or adoption of a child.  The SECURE Act 2.0 also contained many provisions that expanded taxpayers' ability to access retirement funds without penalty.  One new provision will allow taxpayers to withdraw up to $2,500 each year to cover the costs of long-term care insurance without triggering the 10 percent early withdrawal penalty.  Beginning in 2024, plan participants will be entitled to take penalty-free withdrawals if the participant certifies that they have been a victim of domestic violence by a spouse or domestic partner within the one-year period prior to the withdrawal.  Taxpayers who have been certified by a physician as being terminally ill are also now permitted to take penalty-free withdrawals.

We asked two professors and authors of ALM’s Tax Facts with opposing political viewpoints to share their opinions about expanding the hardship distribution rules to allow for penalty-free distributions for different reasons.

Below is a summary of the debate that ensued between the two professors.

Their Votes:





Their Reasons:

Bloink: One of the primary reasons that Americans fail to take advantage of tax-preferred retirement savings options is the fear of needing the funds prior to retirement and incurring penalties on top of ordinary income tax rates for hardship withdrawals.  Expanding the limited list of reasons why a participant can access retirement funds without penalty is key to encouraging increased retirement savings.

Byrnes: Expanding the hardship distribution rules only serves to encourage leakage from these retirement plans.  The early withdrawal penalties exist for a very good reason.  If retirement accounts are simply treated as any other type of savings account, taxpayers are given a powerful tax break without the strong incentive to allow those funds to remain in the retirement account.

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Bloink: The list of reasons for penalty-free retirement distributions is not endless--and participants are required to certify their legitimate need for the funds.  That provides built-in safeguards.  Further, distributions are never tax-free.  We’re only talking about allowing taxpayers to access their own hard-earned funds for legitimate hardship-based reasons.

Byrnes: Plans that allow hardship distributions may now rely on the employee’s certification as to the existence of the hardship and the amount needed.  That essentially means that employees can access their tax-preferred retirement funds for any reason whatsoever.  This is not how tax-preferred retirement accounts are meant to function.

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Bloink: Without these types of hardship expansions, lower-income taxpayers are much less likely to adequately save to fund retirement.  Essentially, this is a type of compromise.  In the end, expanding the explicitly stated reasons for hardship distributions narrows the field and allows employers to provide clear limits on the reasons that penalty-free distributions will be permitted.

Byrnes: Pre-SECURE Act, we already had a list of legitimate reasons for penalty-free withdrawals prior to retirement.  Any expansion does more harm than good in that it gives participants legitimized reasons to drain their retirement savings--and retirement saving is something that we should be trying to increase, which is why the early withdrawal penalty taxes exist in the first place.