WASHINGTON-In trying to close a loophole that allows employees to escape taxes on 401(k) hardship withdrawals, Congress may not have gone far enough.A provision in a law overhauling the Internal Revenue Service enacted by Congress this year that will partially close the tax loophole is likely to confuse employees and burden employers."This is a big deal and a huge headache," warns Frank Roque, a consultant with Hewitt Associates L.L.C. in Lincolnshire, Ill.Mr. Roque hopes legislators eliminate the problem by amending the law or at least give employers more time to comply with the new law, which takes effect in 1999.The provision that closes the hardship withdrawal loophole has its origin in legislation signed into law last year that exempted certain distributions from individual retirement accounts from a 10% penalty tax that normally applies to pre-retirement withdrawals.Specifically exempted from the 10% tax are funds withdrawn from IRAs used for a first-time home purchase and for higher-education expenses.The 1997 law kept the 10% penalty tax in place, however, for these and other types of hardship withdrawals from 401(k) plans.Savvy employees and financial consultants, though, quickly discovered how employees willing to undertake a little extra work can escape the 10% penalty tax on 401(k) hardship withdrawals.First, an employee takes a hardship withdrawal from the 401(k) plan and rolls over the distribution to an IRA. After that, the employee withdraws the funds from the IRA and uses the money toward a first-time home purchase or higher-education expenses. See Loophole on page LoopholeContinued from page 1Through this simple, two-step procedure of rolling over 401(k) hardship withdrawals to an IRA, employees do not have to pay the 10% penalty tax that would apply if they took the money straight out of the 401(k) plan and did not use an IRA conduit.Perhaps aware of a tax loophole it did not mean to create, Congress tried to close it. Included in the IRS Restructuring And Reform Act of 1998 is a provision effective Jan. 1, 1999, that says hardship withdrawals of employees' pretax 401(k) salary deferrals no longer can be rolled over to an IRA.However, the new law will allow employees to continue to withdraw other funds from their savings plans, such as employers' matching contributions, and roll over that money to an IRA.Those other savings plan funds rolled over to an IRA and then withdrawn to pay for either a first-time home purchase or higher educational expenses will continue to be exempt from the 10% early withdrawal penalty tax.As a result of this continued, different tax treatment on 401(k) savings plan funds, the 10% penalty tax loophole is only partially closed.For employers, this will present a big administrative hassle. That is because of other IRS regulations that have the effect of requiring employees taking hardship withdrawals from 401(k) plans to often withdraw a combination of employee pretax contributions and other funds.When the new law goes into effect, employees withdrawing a combination of funds will face different withdrawal rules and taxes, a big change from today's simple withdrawal structure.Take the case of an employee who wants to take a hardship withdrawal of $5,000, consisting of $3,000 in pretax contributions and a $2,000 employer match. Today, the employee could simply transfer the $5,000 to an IRA.Under the new law, though, the withdrawal options jump several fold when two types of money-pretax and other savings plans funds-are withdrawn.For example, employees will have to be told that their pretax contributions can't be rolled over to an IRA.Employers also will have to explain that other savings plan funds, though, can be directly transferred to an IRA without the penalty tax."This really doubles the amount of information employees have to be given," Mr. Roque said.More significantly, the automated 401(k) payment systems many plan administrators now have in place will have to be overhauled to try to mesh with the new environment of one set of hardship withdrawal rollover rules for employees' pretax contributions and a different set of rules for other savings plan funds."You are going to have to change check-writing and notification procedures. You are going to have to change forms, computer programs and the interaction between employers, employees and recordkeepers," Mr. Roque said."All those changes have to be in place in just 41/2 months. I'm not that optimistic that all employers will be able to make this deadline," he added.Such an overhaul of savings plan administration would not be necessary if Congress had gone one step further and fully closed the 10% early withdrawal tax penalty by closing off IRAs from tax-free rollovers of hardship distributions of all savings plan funds.Indeed, Mr. Roque said he wouldn't be surprised if legislators' partial close of the IRA loophole was unintentional."I believe it was an oversight," he says. Given the expense employers will incur by complying with the new law, Mr. Roque said a logical step for Congress would be to pass legislation in the remaining weeks of the session to make clear whether it did indeed want to only partially close the loophole or to completely close the loophole.Alternatively, Congress or the IRS could give employers more time to comply, he said.