As explained in a newly published “IRS Snapshot,” a 401(k) plan may permit pre-retirement distributions to be made on account of participants experiencing financial hardships. A hardship is defined as an “immediate and heavy financial need,” and the distribution must be declared by the participant to be necessary to satisfy an immediate financial need.
Generally speaking, employees’ contributions—rather than employer matching dollars—have been drawn upon to meet hardship withdrawal requests. But if the plan sponsor permits, IRS explains, certain employer matching contributions and employer discretionary contributions may also be distributed on account of a hardship, although the standards for distributions may be different.
For plan years beginning prior to 2019, qualified matching contributions, qualified nonelective matching contributions, and income earned on elective deferrals could not be distributed on account of a hardship. These restrictions were lifted for plan years starting in 2019, however, and more changes are on the horizon due to the requirements of the Bipartisan Budget Act of 2018.
As the IRS explains, the Bipartisan Budget Act of 2018 made several important updates to the requirements for making and monitoring hardship distributions from tax-qualified retirement plans. In particular, the Act provided that a distribution from a 401(k) or similar qualified plan will not fail to be treated as made on account of hardship merely because the employee did not first exhaust any available loan from the plan.
In addition to expanding the types of contributions and earnings a plan may make available for hardship distributions, the law directed the IRS and Treasury Department to eliminate the safe harbor requirement to suspend participant contributions for six months in order for the distribution to be deemed necessary to satisfy an immediate and heavy financial need. Among still other changes, the Act ordered employers and the IRS to allow participants to more easily certify that they are experiencing a financial hardship.
As reviewed in the Snapshot, responding to the Bipartisan Budget Act, the IRS has put forward a proposed regulation to replace the previous requirement for a detailed and document-supported representation of hardship with “a general written statement that the employee has insufficient cash or other liquid assets to satisfy the need,” effective for distributions made on or after January 1, 2020. The IRS Snapshot points out that “whether an employee has an immediate and heavy financial need depends on all relevant facts and circumstances,” and that, broadly speaking, when the proposed rule becomes final, an employer may confidently rely on the employee’s representations unless the employer has actual knowledge that the representations are false.
While the hardship withdrawal rules are, in a sense, becoming more lenient, there are still restrictions. Pursuant to the “safe harbor” provisions most plan sponsors seek to comply with, a distribution is deemed to be on account of an immediate and heavy financial need of the employee if the distribution is for:
- Generally, expenses for medical care previously incurred by the employee, the employee’s spouse, or any dependents of the employee or necessary for these persons to obtain medical care.
- Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments).
- Payment of tuition, related educational fees, and room and board expenses, for up to the next 12 months of postsecondary education for the employee, or the employee’s spouse, children, or dependents.
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
- Burial or funeral expenses for the employee’s deceased parent, spouse, children, or dependents.
- Certain expenses relating to the repair of damage to the employee’s principal residence that would qualify for the casualty deduction under IRC § 165.
- The plan may also permit distributions for medical care, tuition, and funeral expenses for certain beneficiaries of the participant, per IRS Notices 2007-7 and 2007-1.
The IRS Snapshot notes that many plans may continue to use more detailed policies and procedures already in place for documenting participants’ requests and receipts of hardships distributions. The recent changes, in other words, allow but do not require plans to be more lenient about the certification and monitoring of declared hardships. And, however a plan sponsor chooses to proceed, it will also be important to ensure the plan remains compliant when it comes to the treatment of records and documents tied to pre-2019 hardships distributions.
With all this in mind, the IRS Snapshot includes the following audit tips:
- Review the plan document and stated hardship policies.
- Examine the hardship distribution form(s) and any written statements provided by the employee for proper signatures, especially spousal consent (if applicable).
- Make sure that the distribution is limited to the maximum distributable amount related to the source of the funds.
- Examine the records the employer used to establish whether a hardship exists and the amount of the hardship. Records containing the necessary information may include, but aren’t limited to, medical bills, tuition bills, eviction notices, or closing sheets for the purchase of a principal residence.
- For elective deferrals, examine the documentation provided by the employee to determine that the employee has no other reasonably available resource to relieve the hardship. This can be limited to an employee representation.
- For elective deferrals, for plan years beginning prior to January 1, 2019, verify that the employee obtained available distributions and loans and was prohibited from making contributions for six months after the hardship distribution.
- Examine the returned check(s).
- Examine the trust fund statement.
- Make sure the distribution is properly reported on Form 1099-R.
- Look for indicators of fraud.