Congress and Federal Agencies Provide Hurricane Katrina Disaster Relief Affecting Employee Benefit Plans

Congress, the Internal Revenue Service and the Department of Labor have moved quickly during the last several weeks to provide disaster relief to both participants and sponsors of employee benefit plans affected by Hurricane Katrina. This Alert summarizes the relief that has been provided to date. It is quite possible that more relief will be granted in the next few weeks.

CAUTION: Congress and the agencies have not been consistent in defining who has been affected by the disaster and therefore qualifies for each item of relief. There are differences in such things as the geographic areas covered, the applicable time periods, and the relationship of the individual to the disaster area. This brief Alert does not cover all of those details. If you are going to rely on a particular item of relief, you will need to check the relevant law or notice to determine who qualifies for that relief.

FURTHER CAUTION: Some of the relief that has been granted is optional -- i.e., the employer is not required to modify the rules of its benefit plans to permit participants to take advantage of the relief if it does not wish to do so. However, the extensions described below of the grace period for repaying plan loans and the election periods for COBRA, HIPAA special enrollments, etc. are mandatory for all employers.

Katrina Emergency Tax Relief Act of 2005: On September 23rd, the President signed the Katrina Emergency Tax Relief Act of 2005 into law This Act provides special rules for distributions and loans from retirement plans to "qualified individuals," defined as persons whose principal place of abode on August 28, 2005 was located in a Hurricane Katrina disaster area and who suffered an economic loss due to the Hurricane.

10% penalty on early withdrawals waived. Distributions from retirement plans are normally subject to a 10% early withdrawal penalty in order to promote retirement savings. The 10% penalty is waived for "qualified Hurricane Katrina distributions" which are made from an "eligible retirement plan" to a qualified individual between August 25, 2005 and January 1, 2007. Qualified distributions are limited to a total of $100,000 to any participant in that participant's lifetime. The dollar limit further applies to all eligible plans in the employer's controlled group. Eligible retirement plans include 401(k) and other qualified plans, IRAs, 403(b)'s and 457 plans. It is not clear whether the Act permits plans that normally cannot allow in-service withdrawals to add such withdrawals for Hurricane Katrina victims. For example, defined benefit and money purchase pension plans generally cannot permit in-service distributions before normal retirement age, and the Act does not appear to change this rule. Plans that do not now permit such distributions must be amended later to do so (see "Timing for Amendments" below). In addition, the 20% tax withholding that would normally apply to non-hardship distributions does not apply to qualified Hurricane Katrina distributions.

Distributions may be repaid, or taxes can be spread over 3 years. An individual who receives a qualified Hurricane Katrina distribution is allowed to repay the distribution to any plan that accepts rollovers at any time during the three years after receipt. The plan should report the distribution for tax purposes in the year the distribution is paid. Then, if the individual later repays the distribution, the repayment is treated as a 60-day rollover at that time, and the individual would file an amended tax return and claim a refund. If the individual does not repay the distribution, he or she can instead elect to have the distribution included in income over three years, beginning with the year of the distribution.

Repayments of hardship withdrawals permitted. An individual who received a hardship withdrawal from a qualified plan (or a distribution from an IRA that qualified for the first-time homebuyer exception) that was intended for use in building a home in the Hurricane Katrina disaster area may repay the amount of the distribution to any plan that accepts rollovers. The distribution must have been received between February 28, 2005 and August 29, 2005, and the repayment must be made between August 25, 2005 and February 28, 2006.

Loan rules changed. Many 401(k) plans and other qualified plans permit participants to receive loans. The Internal Revenue Code imposes amount restrictions and repayment timelines on these loans. The Act increases these limits.

• New loans. For new loans to qualified individuals made between September 23, 2005 and January 1, 2007, the maximum outstanding loan amount is increased to the smaller of 100% of the participant's account balance or $100,000. (Note: Before loans can be granted in excess of the normal 50% limit, additional ERISA relief from the Department of Labor may be necessary.)

• New loans and existing loans. The Act imposes a mandatory grace period for repayments on any plan loan that is outstanding to a qualified individual between August 25, 2005 and December 31, 2006. The due date for any repayment normally due during this period is delayed for one year, although interest is required to continue to accrue on the delayed repayments. (Presumably, a qualified individual could waive the grace period and continue making payments as usual.) In addition, this extra grace period will not cause a loan to violate the 5-year maximum limit that applies to most plan loans. It is not clear from the Act how plans should treat loans at the end of the grace period, but it will likely be acceptable to reamortize the loan to account for the delayed repayments. More guidance on this issue will be needed.

Timing for amendments. Employers have until the end of the first plan year beginning on or after January 1, 2007 (i.e., until December 31, 2007 for a calendar year plan) to amend their plans to take advantage of this relief, as long as they operate their plans in accordance with the changes in the law in the interim, and the amendment is retroactive. (It is not clear if amendments will be required if the only relief the employer adopts is the mandatory extended grace period for plan loans.)

IRS Relief: In Notice 2005-73 and Announcement 2005-70, the IRS provided relief in the following areas:

Filing deadlines. An employer whose principal place of business is in a Hurricane Katrina disaster area, or whose plan records are in such a disaster area (for example, if the plan's recordkeeper is located there), has until January 3, 2006 to file 2004 Forms 5500 and to make certain other tax filings, if the filing deadline would have fallen after August 29, 2005.

Hardship withdrawals. A 401(k) plan that allows hardship withdrawals normally has a maze of requirements to track. The withdrawal must be necessary to meet an immediate and heavy financial need, the participant must substantiate the hardship reason, and the participant's future deferrals to the plan must be discontinued for six months. In light of the difficulties facing participants who were affected by Hurricane Katrina, the IRS liberalized the hardship rules for withdrawals by such participants that are made between August 29, 2005 and March 31, 2006 as follows:

• The plan is permitted to rely on the participant's representation regarding the need for, and the amount of, the withdrawal.
• The participant is not required to suspend future pre-tax deferrals during the following six months.

A Hurricane Katrina hardship withdrawal can be made to an employee or former employee whose principal residence or place of employment was in a Hurricane Katrina relief area, or who had a lineal ascendant (i.e., parents, grandparents) or lineal descendant (i.e., children, grandchildren) that resided or worked in the disaster relief area.

Joint IRS and Department of Labor Relief: The IRS and Department of Labor have issued mandatory rules extending certain time limits imposed on employees under medical, dental and other welfare plans. This relief applies to any participant, beneficiary, COBRA qualified beneficiary or claimant who resided, lived, or worked in one of the designated Katrina disaster areas.

Under these rules, employers must disregard the period from August 29, 2005 to January 3, 2006 for purposes of compliance with the following:

• The 30-day deadline for special enrollment events under HIPAA (for example, adding a newborn baby).

• The 60-day deadline for electing COBRA coverage.

• The 45-day and 30-day grace periods for making COBRA premium payments.

• The 60-day time period for participants who experience certain COBRA qualifying events (divorce, child ceasing to be a dependent, etc.) to provide notice to the employer or plan administrator.

• All claims filing deadlines and appeal deadlines.

Other Hurricane Relief: The Katrina Emergency Tax Relief Act provides other relief that may be of interest to some employers, including a work opportunity tax credit for certain employees and a credit against tax for a portion of wages paid to affected employees. The IRS is also encouraging leave donation programs, which allow employees to forego vacation or other paid leave in return for the employer making a cash donation in the amount of the foregone leave to charities providing Hurricane Katrina relief.