Wildfire Victims May Find Financial Relief in Retirement Plans

If Los Angeles-based employers are looking to help their employees impacted by wildfires but are unsure where to begin, some financial relief may be readily available through employer-sponsored retirement plans.

Participants in qualified retirement plans—certain 401(k) and 401(a) plans—and 403(b) or governmental 457(b) plans generally can take out a participant loan for $50,000 or 50% of the participant’s vested benefit, whichever is less, as long as the plan allows it.

But the SECURE 2.0 Act increased the maximum permissible loan amount for residents in a disaster area who suffered an economic loss due to a “qualified disaster,” deemed so by a presidential declaration. Former President Joe Biden declared the wildfires a major disaster, and the Federal Emergency Management Agency designated Los Angeles County as a qualified disaster area.

As a result, certain plan participants who reside in Los Angeles County may borrow up to the expanded loan limit, which is the lesser of $100,000 or 100% of the participant’s vested benefit.

Most retirement plan loan provisions set the interest rate at “prime plus 1%.” The prime rate is a benchmark interest rate that banks charge their most creditworthy customers, and most retirement plans charge 1% in addition to the prime rate. If employees are concerned that their credit scores aren’t high enough to obtain a personal loan at a reasonable rate, their retirement plan may provide a more affordable opportunity.

Unlike traditional loans where interest payments go to the lender, employees will repay a retirement plan loan to their personal retirement plan accounts. When employees take out a loan from a retirement plan, they effectively borrow money from their own account.

The plan that lends the money treats the loan as an investment and interest payments as return on investment. This means the employee’s retirement account will continue to grow despite the loan, assuming loan repayments are made timely.

Most retirement plans don’t penalize the borrowing employee for an early payoff with a prepayment penalty. Even though California law generally prohibits a prepayment penalty, penalties are permitted in certain situations in the context of real estate-backed loans. If an employee can repay a large portion of the loan within a short period of time, a retirement plan may be an attractive option.

Additionally, most retirement plan loans charge a flat fee, generally ranging from $100 to $400 per loan, which would be significant savings compared to origination fees charged by banks that generally are based on a percentage of the borrowed amount.

Section 331 of SECURE 2.0 provides an alternate method by which an employee can receive up to $22,000 from the individual’s qualified plan, 403(b) plan, or governmental 457(b) plan, to the extent the plan permits in-service distributions. Employees may receive a qualified disaster recovery distribution if their principal place of abode is in a qualified disaster area and they suffer an economic loss from the disaster.

Eligible employees may receive such distribution up to 179 days after the latest of: the enactment date of SECURE 2.0, the first incident date, or the day the presidential declaration occurred. Because the presidential declaration was the last to occur, eligible employees impacted by Los Angeles wildfires may seek a qualified disaster recovery distribution until July 6, 2025.

A qualified disaster recovery distribution avoids the 10% early distribution penalty tax and mandatory 20% withholding applicable to eligible rollover distributions from qualified plans. While the distribution is taxable, the employee receiving the distribution may spread out the income tax over three years beginning with the year of distribution.

The employee may recontribute the distribution to the plan within three years, and such recontribution is generally treated as a direct trustee-to-trustee transfer within 60 days of the distribution–essentially turning the distribution into a tax-free qualified plan rollover. This means an eligible employee could use up to $22,000 without paying any taxes if the full amount is recontributed to the plan.

In addition to the two plan provisions described above, there are other options such as hardship distributions (or unforeseen emergency withdrawal for governmental 457(b) plans) and pension-linked emergency savings accounts that may already be established in a retirement plan to further assist employees.

Employers should be familiar with provisions in their employer-sponsored retirement plans so they can provide much-needed resources to the employees who require financial assistance during this challenging time.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Alison Wright is partner and Soohuen Ham is an associate in the employee benefits practice group at Hanson Bridgett.

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