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October 2020

IRS Guidance on Difficulty of Care Payments Affect on IRAs and Retirement Plans

Some individuals in the past who were not eligible to make an IRA contribution may now do so, These individuals are workers who receive difficulty of care payments related to their foster care services.

Internal Revenue Code section 131 provides that a difficulty of care payment, which is a type of foster care payment, is excludable from the taxpayer’s gross income. Under pre-2020 law, such payments were not considered to be qualifying compensation for purposes of making an IRA contribution. The general rule is, in order to make an IRA contribution, regardless if deductible or non-deductible, a person must have taxable income to support the contribution.
In Notice 2020-68 the IRS provides additional guidance.

A new exception to this rule is made for difficulty of care payments. Code section 408(o)(5) was added by the SECURE Act. It provides that an individual with difficulty of care payments is eligible to make certain designated nondeductible contributions to an IRA even though the person does not otherwise have sufficient compensation to make an IRA contribution (lesser of $6,000 if under age 50, $7,000 if age 50 or older or 100% of compensation).

These designated nondeductible contributions are limited. An individual is eligible to make a non-deductible IRA contribution to the extent of the lesser of the amount excluded under section 131 or the maximum IRA contribution amount as reduced by the amount of compensation which is includible in income. For example, Jane Doe, age 39, receives compensation of $11,000 for certain difficulty of care payments. She is able to exclude $9,000 under section 131 and she includes $2,000 in her taxable income. She is limited to make a non-deductible contribution of $4,000. The $4,000 is the lesser of $6,000 as reduced by the $2,000 or $9,000. If Jane Doe’s excludable difficulty of care payments were $5,000 and she has no other taxable compensation, then her nondeductible IRA contribution amount would be limited to $5,000.

The IRS has stated that it will be providing guidance on how the excess contribution rules and reporting are affected by these new difficulty of care payment rules. The IRS will also need to provide guidance if a person is eligible to make a Roth IRA contribution based on difficulty of care payments.

Difficulty of care payment also impact contributions which are made under a qualified plan. In general an employer will make a contribution for a participant only if a participant has compensation for the current year. And the law imposes a maximum amount which can be contributed on behalf of a participant. Under pre-2020 law, difficulty of care such payments were not considered in applying the limitations on annual additions set forth in code sections 415(c)(1) and (2). Under section 415(c)(1 ), a person’s annual additions may not exceed the lesser of $40,000 as increased by annual cost of living adjustments ($57,000 for 2020) or 100% of the participant’s compensation. Under section 415(c)(2) a person’s annual additions are the sum of the employer contributions, employee contributions and forfeitures.

As revised by the SECURE Act a person’s compensation for section 415 purposes is increased by the amount of excludable difficulty of care payments. Thus, a person may make contributions to their account or receive allocations to their account based on these difficulty of care payments even if the person has no other compensation. Such a contribution is treated as investment in the contract and will not cause a plan to be treated as failing any requirements of code sections 1-1400Z-2. This law change applies to plan years beginning after December 31, 2015. It appears the IRS position is, this law change is a mandatory change and it is not a permissive or discretionary change.