Your 401(k) and the tax bill: Contribution limits would remain untouched, but other changes may be coming

  • Theo Thimou
  • Clark.com
3:05 p.m Thursday, Nov. 9, 2017 Business

When the Tax Cuts and Jobs Act was unveiled by House Republicans last week, a lot of attention was dedicated to what wouldn’t happen with your 401(k).

Namely, the tax bill didn’t drastically lower 401(k) retirement account contribution limits as some feared it would.

But other changes could be coming to your 401(k) plan under the proposed tax bill that you should be aware of.

RELATED: 14 things to know about Social Security in 2018

These proposed 401(k) changes are flying under the radar

Longer loan repayment terms

Currently, you have 60 days to pay back a 401(k) loan with no penalty if you leave your company or the retirement plan at your employer terminates for some reason.

If you don’t get it paid off during that 60-day window, the money gets treated as a taxable distribution. Plus, you could also get hit with an additional 10% penalty if you’re under 59½.

The new tax bill, however, proposes stretching that 60-day repayment term out much longer — until when you file your tax return for the year in which you take the loan.

That would be a big change if this provision of the tax bill get passed as written!

Let’s illustrate this proposal with a real-world scenario: Say you take a 401(k) loan on January 1, 2018 and then leave you company the next month. If the tax bill gets passed as written, you would have until April 15, 2019 to pay that money back without penalty.

(Editor’s note: Money expert Clark Howard generally isn’t in favor of 401(k) loan. Before you consider taking a 401(k) loan in your life, read this piece about the hidden costs.)

Hardship distributions won’t bar you from contributing

There are two big proposed changes here related to hardship distributions.

First up, the tax bill as written would let participants keep saving in their retirement plan as regularly scheduled even after taking a hardship distribution.

This would be a change from current rules that say employees have to stop making contributions for six months following a hardship distribution.

Another change the Tax Cuts and Jobs Act proposes is allowing plan sponsors (your employer) to let you tap into both account earnings and employer contributions to gather up money for a hardship distribution.

That’s a marked change from current rules that state hardship distributions can only come from your contributions — not the employer match or any gains on your investments.

As a reminder, we should note that employers are not required to offer you hardship distributions from their plan. But some choose to. The IRS has general guidelines on what circumstances warrant a hardship distribution.

Lower age limits on distributions

If you have a pension plan at work, you currently have to wait until you’re 62 to take what’s called an in-service distribution.

Investopedia defines an in-service distribution or withdrawal in the following way:

“A withdrawal made from a qualified plan account before the holder experiences a triggering event. A triggering event, such as reaching a certain age, or leaving an employer, is often needed to be able to withdraw funds from a plan, such as a 401(k).”

Under the tax bill proposal, that age limit would be lowered to 59½.

No more recharacterization of Roth IRA conversions

This one’s a little complicated, but stick with us…

Sometimes financial advisors will have a client take pre-tax money, pay the tax on it and convert it to an after-tax account like a Roth IRA. That’s called doing a Roth IRA conversion.

But under certain market circumstances, it might be advantageous to undo the conversion and make the money pre-tax again. That’s considered a recharacterization; it’s basically just converting Roth money back to pre-tax money.

Got that?

OK, good. The next thing you need to know is that the Tax Cuts and Jobs Act aims to disallow the recharacterization that would undo the conversion.

Think of it like this: The tax bill says it’s OK to have a one-way ticket to Roth World (aka doing a Roth IRA conversion), but you shouldn’t get a round-trip pass that lets you go to Roth World and then travel back again to 401(k)sville — in other words, do a recharacterization.

Fortunately, this is a provision that would impact financial planners the most, not the average 401(k) saver.

Tax bill watch: Where do we go from here?

If you’re following developments closely, you know the House bill is moving through committee right now.

Next up, the Senate will have to propose its own version of tax legislation.

Then by the end of the process, both the House and the Senate will have to try to reconcile their differences in proposed legislation before the tax bill can become law.

RELATED: Tax Cuts and Jobs Act: Here are the key takeaways you need to know

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