SECURE 2.0 Act Adds New Penalty Tax Exception for Terminal Illness
By Mike Rahn, CISP
Assets accumulated in IRAs and employer-sponsored retirement plans are intended to be retained for the primary purpose of meeting post-retirement needs of the saver and others who depend on him for financial support. The IRS discourages using these savings for other purposes by imposing an additional 10 percent penalty tax on the taxable portions of premature distributions. In this case, “premature” is generally any time before age 59½, though for some employer-sponsored retirement plans, this age may be 55 or even age 50.
The key term here is “can be applied,” because the Internal Revenue Code contains multiple exceptions to the penalty tax for premature withdrawals from these accounts. In recent years Congress has steadily expanded the circumstances under which penalties will not be applied to premature distributions from IRAs and employer-sponsored retirement plans.
The SECURE 2.0 Act of 2022 is the latest legislative event to expand these exceptions. One new exception is for the terminal illness of a retirement plan participant or IRA owner. The provision applies to terminally ill distributions made after December 29, 2022. The rationale for this new exception is the potential need of an individual to use retirement funds for expenses related to a terminal illness.
What Plans are Covered?
This new SECURE 2.0 provision broadly covers premature distributions from most employer-sponsored retirement plans: those qualified under Internal Revenue Code Sections 401(a)—which includes 401(k) and other defined contribution plans and defined benefit plans—as well as 403(b) plans and 403(a) annuity plans. The provision also applies to Traditional, SEP, SIMPLE, and Roth IRAs.
Physician Certification Needed
Understandably, qualifying conditions apply to this penalty tax exception. The most important of these is a certification by a physician that the IRA owner or retirement plan participant has an illness that is expected to lead to death.
Required Contents of a Physician’s Certification
A statement that the individual’s illness or physical condition can be reasonably expected to result in death in 84 months, or less, after the date of certification.
A narrative description of the evidence that was used to support the statement of illness or physical condition.
The name and contact information of the physician making the statement.
The date the physician examined the individual or reviewed the evidence provided by the individual, and the date that the certification is signed by the physician.
The signature of the physician making the statement, and an attestation from the physician that, by signing the form, the physician confirms that the physician composed the narrative description based on the physician’s examination of the individual or the physician’s review of the evidence provided by the individual.
Must Employers Permit Distributions for Terminal Illness?
While IRA owners always have access to IRA distributions, employer-sponsored retirement plans have more restrictions. Attaining a specified age, leaving employment, incurring a hardship, plan termination, etc., are among the events that may be required to make funds available for distribution. Employer contributions, however—including matching and profit sharing contributions—may be made available as “in-service distributions” under more liberal terms than an employee’s salary deferral contributions.
Terminal illness may, but is not required, to be specified as an event that qualifies for an in-service distribution. If terminal illness is among a plan’s in-service events, the physician’s certification described above must be presented to the employer; mere self-certification of a terminal illness condition by the plan participant is not sufficient.
However, regardless of whether an employer plan officially recognizes terminal illness as an in-service distribution event, an individual who is eligible for a distribution under any plan provision may—if meeting the statutory conditions—treat that distribution as penalty-free when filing her tax return.
Can All Plan Assets be Made Available for a Terminal Illness Distribution?
Salary deferrals made to a 401(k) or 403(b) plan generally may not be distributed before age 59½, except when leaving employment, with plan termination, or under an optional plan provision permitting distribution for hardship reasons. This SECURE 2.0 provision did not create a new distributable event for salary deferrals.
NOTE: Proposed legislation containing SECURE 2.0 technical corrections would elevate terminal illness to the status of a distributable event for salary deferrals, as a plan option.
How Will Terminal Illness Distributions be Reported?
The only reporting guidance given by the IRS to date is found in Notice 2024-02, described by some as a “grab bag” of guidance on multiple SECURE 2.0 provisions. In Notice 2024-02, the IRS has indicated that taxpayers may file IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, with their Form 1040, U.S. Individual Income Tax Return, to claim the exception to the 10 percent penalty tax.
Notice 2024-02 seems to indicate that taxpayers would file Form 5329 only if their employer’s plan does not offer terminal illness distributions. But at the time of this writing, the IRS had yet to release guidance as to how employers or IRA custodians must report terminal illness distributions as exempt from the 10 percent penalty tax. Additional guidance is needed to clarify how the IRS expects a penalty tax exception to be claimed or confirmed, under all circumstances.
Is There a Limit on the Terminal Illness Distribution Amount?
There is no dollar limit on a terminal illness distribution, assuming all qualifying conditions are met.
May Terminal Illness Distributions be Repaid?
Similar to distributions for certain natural disasters, amounts distributed under provisions of the CARES Act during the COVID-19 pandemic, or under qualified birth or adoption distribution (QBAD) rules, amounts received as terminal illness distributions may be repaid—up to the amount distributed—within three-years. IRS Notice 2024-02 states that “…the recipient may recontribute any portion … to a qualified retirement plan … to which a rollover can be made under sections 402(c), 403(a)(4), 403(b)(8), or 408(d)(3).” This includes IRAs and most employer-sponsored retirement plans.
IRS Notice 2024-02 states that a recontribution of terminal illness distributions will be done “following rules similar to qualified birth or adoption distributions.” The 2024 IRS Instructions for Forms 1099-R and 5498 do not address recontribution of terminal illness distributions, but do specify that QBAD recontributions to an IRA are to be reported in Box 14 of Form 5498, IRA Contribution Information, using a special indicator code. This suggests that terminal illness distribution amounts repaid to an IRA could have a similar reporting regimen on IRS Form 5498. (There is no comparable reporting for recontributions to employer-sponsored retirement plans.)
Amending for Terminal Illness Distributable Events
Nongovernmental employer-sponsored retirement plans that choose to add terminal illness as a distributable event must amend for this provision by December 31, 2026. Plans may operationally comply with the conditions of this SECURE 2.0 provision in the interim.
Steps for the Taxpayer
As noted above, if an employer plan does not adopt terminal illness provisions, a plan participant who has taken a premature distribution for terminal illness reasons will report it on IRS Form 5329 when filing her federal tax return. Importantly, the physician’s certification and supporting documentation should be retained with tax records as evidence of an individual’s eligibility for an exemption from this penalty tax.
What We Don’t Know
The SECURE 2.0 Act and limited post-enactment IRS guidance have not addressed the reporting, and importantly the tax consequences of, permitted repayment of a terminal illness distribution within the three-year window. As noted above, the 2024 IRS Instructions for Forms 1099-R and 5498 do not directly address recontribution of terminal illness distributions. They do, however, specify that QBAD repayments to an IRA are to be reported in Box 14 of Form 5498 using a special indicator code. Inasmuch as the IRS has stated that QBADs will be the model for terminal illness distributions, we consider it plausible that there may be similar reporting for terminal illness repayments to IRAs. So far, there has been no guidance on either taxpayer or retirement plan reporting for repayments to an employer-sponsored retirement plan.
Because terminal illness distribution recipients will have paid any applicable income tax associated with amounts withdrawn from an employer plan or IRA, will a repayment be considered after-tax—and create basis—in the account to which it is returned? There is precedent for similar repayment events to recover pre-tax status, CARES Act distribution repayments being a notable example. At this time, however, the IRS has not provided guidance on the tax consequences of terminal illness distribution repayments.
And, as also noted above, there is technical corrections legislation pending in Congress which—if enacted—would make terminal illness a new distributable event in employer-sponsored retirement plans.
More to come.
