The recent flurry of hurricanes Harvey, Irma, Maria and Nate have resulted in a loss of life and widespread damage to homes and businesses and the uprooting of many families. Eventually, people will try to repair or rebuild their homes. Due to the unprecedented level of rain and flooding, thousands of homes have been severely damaged. When the damage is due to flooding—and it is estimated that 85% of all homeowners didn’t have flood coverage in Texas even after FEMA aid and other grants and assistance—people will still need funds to pay for repairs.
Damage from Hurricane Irma was more wind driven and as a result most homeowners’ policies will cover wind damage up to the policy limits, while Hurricane Maria involved both severe wind and rain. For Florida coastal homeowners, their wind coverage has a wind deductible which typically varies with the size of the policy. Consequently, even with wind coverage, many policyholders could have a substantial out-of-pocket deductible to fund.
It is challenging for defined contribution (DC) plan advisers to provide guidance to clients under these circumstances. The reason is that given the magnitude of the number of people impacted by the four hurricanes, it can be assumed that regulatory and legislative remedies will be enacted to help with the repair and rebuild burden. For people impacted by the hurricanes, the IRS is allowing DC plan sponsors to broaden the usual hardship withdrawal criteria to meet hurricane related expenses as well as their procedures for facilitating plan loans. Also, the normal six-month suspension for people receiving hardship withdrawals will not apply. IRS policy updates are available here.
Trying to gauge what assistance may be offered in the future, it might be helpful to recall that Congress enacted a number of tax-relief provisions for people affected by Hurricane Katrina. The measures included waiving the 10% threshold for deducting unreimbursed casualty related losses, waiving the 10% excise tax for retirement plan loans up to $100,000 and with the ability to spread the income tax bill over three years, and a myriad of tax credits for employers to hire people. While advisers cannot count on these specific relief provisions being enacted, the conventional wisdom is that Congress will intervene in the coming weeks or months with some remedies and legislative relief.
Currently, there is no doubt affected people are using savings and their credit cards to get by. But, when savings are gone and considering high credit card interest rates, the DC plan becomes the focus for many. When it comes to accessing funds from a DC plan while working, the conventional wisdom is that doing so will rob an individual’s future standard of living for a current need. However, many people may not have a choice but to draw from tax-qualified retirement savings during such a significant hardship. In a dire situation like this the reality is that people need to assess their “hierarchy of needs” while trying to minimize the damage to their future retirement. Of course, adding to the unknown of what Congress will do is whether the individual, or family’s, employment picture is likely to change due to the impact on their employer.
With that said, when providing guidance advisers should consider the following items:
- Person’s age, income and DC account balance;
- If married, same information for spouse;
- Monthly cash flow;
- Job security prospects;
- Size of need relative to value of house;
- Other savings and opportunities for liquidity (e.g. life insurance loan);
- Any Veteran’s benefits (like the VA’s Specially Adapted Housing benefit) and
- Other significant debts like student loan debt (federal versus private)
Generally, taking a loan will be better than taking an outright distribution. This is especially true if the individual is in a higher tax bracket. However, if the person’s employment prospects (or family income) is not certain and they then lose their job and the loan becomes due—especially if the 10% excise tax isn’t waived—this could create a more adverse outcome. Because advisers can’t tell their clients to wait until Congress acts and depending on the size of the need, it could make sense to tell clients to take a plan loan to meet their immediate needs, but not a major loan, and then await what Congress does to find out what aid is available, such as direct aid and federal loans. If the person still has a significant need and the 10% excise tax has been waived, the person could then decide to repay the loan, and subsequently balance their approach with both a loan and a hardship distribution (especially if Congress provides a 3-year payback).
If the 10% casualty loss deductibility threshold is eliminated along with the 10% excise tax, this would in theory make taking distributions more attractive as the taxable income could be offset by the casualty loss deduction. Again, advisers need to reframe their guidance to fit the context of what Congress may provide. While it is usually not advisable to draw down from retirement accounts, immediate needs take precedence in rebuilding and restoring people’s lives.
Lastly, depending on the extent of the damage, some people may consider “walking away” from their house or filing for bankruptcy. Advisers frankly are not the best sources of guidance for pertaining to such a difficult decision, as there are many nuances between Chapter 13 and Chapter 7 that will only be fully understood by a qualified attorney specializing in bankruptcy.
- Dave Evans CFP, AIFA, is the co-founder of 401kSleuth LLC