Hidden risks of hurricane tax relief

Register now

Victims of Hurricanes Harvey, Irma and Maria — who may need to tap their retirement savings, including IRAs and company plans to rebuild after the storms — have received help from Congress. Whether or not to accept it is more complicated than you might think.

The new law eliminates the 10% early withdrawal penalty on distributions before age 59 ½
and lets savers spread any taxes on withdrawals over three years. It also lets them return the distributions back to their IRAs, 401(k)s and other plans within three years to get a refund of any tax they paid.
But while these provisions sound like a good deal — and may be for some — they are not a free lunch. Financial advisors should consider several risks in helping clients decide if retirement accounts are the best source of these needed funds.

The “Disaster Tax Relief and Airport and Airway Extension Act of 2017,” signed into law on September 29, 2017, provides tax relief for "qualified hurricane distributions" to individuals who live within the disaster areas and suffered economic losses.

For people living in each of the following disaster areas, the distributions must have occurred on or after the following dates to qualify for the tax breaks:

  • Hurricane Harvey: August 23, 2017
  • Hurricane Irma: September 4, 2017
  • Hurricane Maria: September 16, 2017

In all cases, distributions must be made before January 1, 2019.
Here are the benefits:

Qualified distributions are not subject to the 10% penalty that otherwise would apply to funds taken from an IRA or other retirement plan before age 59 1/2.

An individual can take up to $100,000 as a qualified hurricane distribution. This limit applies to the amount taken from all plans combined. Married spouses can each take $100,000, for $200,000 total.

Employer plans are not required to impose 20% income tax withholding on distributions.
While distributions are subject to income tax, the resulting income may be spread over three years to defer the tax due. Or an individual can elect to report the entire distribution in income in the year it occurs.

Individuals can return the qualified distributions back into their retirement accounts within three years, and receive a refund of any tax paid on the distributions. They get the refund by filing amended returns for the years in which the tax was paid.

These tax breaks together may provide valuable financial relief in a time of need, as illustrated in the following fictional situation.


Example: George, age 49, lives in Houston, Texas, where his home was destroyed by Hurricane Harvey. To get through the crisis, he withdraws $60,000 from his IRA on October 19, 2017. Fortunately, his finances recover, and he repays the $60,000 back into his IRA before the three-year deadline of October 19, 2020. In fact, he makes the repayment just before the April 15, 2020 due date of his 2019 tax return. The benefits that George received include:

  • No 10% early withdrawal penalty on the $60,000 distribution.
  • Reduced and deferred cash cost of income tax on the distribution. He paid tax on income of only $20,000 each on his returns for 2017 and 2018, for only $40,000 total. He owed no income tax on the distribution in 2019 because he returned the distribution to his IRA before his tax return for the year was due.
  • Zero net income tax paid overall, after he obtained refunds of his tax payments for 2017 and 2018.

The result is that George effectively received a penalty-free and tax-free bridge loan of $60,000 from his IRA to help him through his crisis.

George's result may seem great, but the benefit wasn't really tax-free and there was serious risk involved in his strategy.

First, even with the income deferral and final tax refund, he still had to pay tax on $40,000 of income while in a cash crisis. He also lost the tax-deferred growth on the $60,000 withdrawn from his IRA until he returned the funds, which could be a significant loss too.

Moreover, if he hadn't been able to pay back the $60,000 in three years, his IRA would have been permanently reduced by the unrepaid amount, with him paying a tax bill on the unrepaid amount that he'd never get back.

Three years is a short time to repay a large amount in a disaster situation, so this was a risky gambit.

Now consider a less ideal scenario.

Example: Harry, like George, takes $60,000 from his IRA to pay for hurricane damage. But Harry's situation does not improve enough for him to return any of the $60,000 to his IRA in three years. He must pay income tax on the full $60,000. (If he doesn't have the money to do so he might be forced to withdraw more from his IRA and wind up paying tax on the money used to pay tax!) Moreover, his IRA is permanently reduced by $60,000, costing him tax-favored investment returns on that amount for the rest of his life.

When advising clients, know these risks and consider IRA distributions only as a last choice option. It may be that in a dire situation, a client must take a distribution, but inform the client of the potential downsides before acting.

A safer strategy might be to seek a loan with a longer term from a conventional lender or through an emergency government-sponsored lending facility. Then there is no need to raise cash to meet a current income tax bill, no loss of tax-deferred earnings and no risk of depleting retirement savings. Plus, there is much more time to repay the borrowed amount.

Another loan option is provided by the Disaster Tax Relief Act itself. The law increases the maximum that employees who live in hurricane disaster areas may borrow from their employer-sponsored qualified retirement plan accounts to $100,000 from the former limit of $50,000, and eases the general rule that limits borrowing to one-half the value of an account so that they may borrow their full non-forfeitable balance. Loans must be taken out after September 29, 2017 and before January 1, 2019. These loan provisions do not apply to IRAs, where loans are prohibited.

Borrowing is income tax free, so this option avoids owing current tax on a distribution and also provides more time to repay funds to the plan. Loans from a plan generally can be repaid over five years.

Also, employees who live in hurricane areas and already held outstanding plan loans prior to the disaster, are eligible for a one-year postponement of repayments.
Another idea is to use a casualty loss deduction to offset the income tax cost of taking a distribution from an IRA or retirement plan to cover the cost of damage to property.

This is a logical concept, and the Disaster Tax Relief Act liberalizes casualty loss rules for hurricane victims, making larger deductions available to many. But be careful — there are traps in the rules for applying this deduction that can make it very risky.

The general rule is that a casualty loss deduction for personal-use property is permitted only to the extent that unreimbursed losses for the year exceed $100 each, and their total exceeds 10% of Adjusted Gross Income. The deduction can be claimed only on an itemized tax return.

In addition, casualty losses suffered in a presidentially-declared disaster area can be deducted on the tax return filed for the year prior to that in which the loss occurred. This can provide two tax benefits: (1) faster monetary relief, as one can immediately file for a refund of tax paid for the prior year; and (2) possibly a larger deduction if, for instance, the individual was in a higher tax bracket or had less AGI in the prior year compared to the current year.

The new act further liberalizes the rules for hurricane victims by removing the 10%-of-AGI limit and allowing hurricane-caused losses to be deducted on non-itemized returns (although the per-loss deduction floor is increased to $500 from $100). These two changes can provide significantly larger deductions for many.

The Disaster Relief Tax Act also gives a tax break to people who don't live in the path of the hurricanes, by giving them larger deductions for their charitable giving.

The new law suspends the normal deduction limits on contributions made to organizations helping storm victims. For instance, normally most people can deduct no more than 50% of their AGI for gifts to charity, and the limit may be only 30% or 20% depending on the kind of property donated and the type of donee recipient.

These limits now do not apply to qualified donations made during the period beginning August 23, 2017 and ending December 31, 2017. Technical rules still do apply to different kinds of donations and gift recipients, so this is another issue to discuss with clients' CPAs. Tell clients that an approaching year-end deadline applies to get the larger deductions for these gifts.

In times of unexpected hardship, financial advisors can be more valuable than ever to their clients. Knowing the tax relief provisions in the Disaster Tax Relief Act and giving top-quality advice can earn a client’s loyalty for years to come.

But also remember that giving superficial advice can be toxic to the client relationship. So never assume that these tax "relief" provisions will help every client, as they all involve risks and potential traps.

The devil is in the details. Consider every client's position in detail before writing a financial prescription.

For reprint and licensing requests for this article, click here.
Tax planning Hurricane Maria Hurricane Harvey Hurricane Irma IRAs 401(k) Retirement planning