The Internal Revenue Service recently issued final regulations governing “safe harbor” hardship withdrawals from Section 401(k) plans. The regulations are effective for distributions made on or after January 1, 2020 and reflect statutory changes and both a liberalization and simplification of existing IRS regulations. In this Benefits Brief, we will provide an overview of the hardship rules, summarize the key changes made, and highlight the actions needed in defined contribution plans that permit hardship withdrawals.
Hardship Withdrawals Generally
Distributions of elective deferrals, qualified matching and qualified nonelective contributions, and safe harbor matching and nonelective contributions (“restricted contribution sources”) from a Section 401(k) plan cannot generally be made earlier than a participant’s termination of employment or attainment of age 59 ½. An important exception to that rule permits withdrawals of amounts on account of an immediate and heavy financial need of a participant and certain related parties where the distribution is necessary to satisfy the financial need.
Profit sharing plans without Section 401(k) features and employee stock ownership plans may also permit hardship withdrawals and generally have more flexibility than Section 401(k) plans with restricted contribution sources in how hardship withdrawals are determined. Likewise, the contribution sources in Section 401(k) plans other than restricted contribution sources are subject to less strict hardship withdrawal rules. Despite that flexibility, most defined contribution plans with hardship provisions follow the Section 401(k) hardship rules described below.
The Hardship Rules Effective January 1, 2020
The following is a summary of the hardship rules effective beginning January 1, 2002, with the key changes in bold.
|Eligible Hardship Expenses||The employee must have an immediate and heavy financial need to obtain a hardship withdrawal. Expenses in the following seven categories are deemed an immediate and heavy financial need:|
1. Expenses for (or necessary to obtain) medical care that would deductible under Section 213(d) of the Internal Revenue Code (without regard to the adjusted gross income limit) for the employee, employee’s spouse, employee’s dependents, or a primary beneficiary of the employee, and which are not reimbursable by insurance;
2. Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);
3. Payment of tuition, related educational fees, and room and board expenses, for up to 12 months of post-secondary education for the employee, employee’s spouse or dependent, or for a primary beneficiary;
4. Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence;
5. Payments for burial or funeral expenses for the employee’s deceased parent, spouse, child or dependent, or for a deceased primary beneficiary;
6. Expenses for repair of damage to the employee’s principal residence that would qualify for the casualty loss deduction without regard to the 10% adjusted gross income limit and regardless of whether the residence is located in a federally-declared disaster area; and
7. Expenses and losses (including loss of income) incurred by the employee on account of a disaster declared by FEMA, provided the employee’s principal residence or principal place of employment at the time of declaration was in the declaration area.
|A plan does not have to permit a hardship for all of the safe harbor events; rather, it can include one or more of the permissible events. |
A primary beneficiary is an individual named as a beneficiary under the plan and has an unconditional right, upon the death of the employee, to all or a portion of the employee’s account balance under the plan. As with the permissible events, a plan that allows hardships does not have to permit hardships with respect to the needs of a primary beneficiary. Previous IRS guidance required that the primary beneficiary be named at the time the hardship for the primary beneficiary arose but it is unclear whether that restriction still applies.
Casualty loss hardships are not required to have occurred in a federally-declared disaster area to qualify.
The FEMA disaster area expenses category is a new provision. It is anticipated that the IRS will no longer issue other exceptions in FEMA disaster areas like they have done regularly in the past. This provision is slightly more restrictive than what the IRS has permitted in the past under those ad hoc time-limited exceptions.
|Distribution is Necessary to Satisfy the Financial Need||Three conditions must be satisfied for the distribution to be considered necessary to satisfy the financial need; certain other conditions may also be imposed: |
1. The distribution cannot exceed the amount required to satisfy the financial need, including amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution.
2. The employee must have obtained all other currently available distributions (including ESOP distributions but excluding hardship distributions) under the plan and all other plans of the employer.
3. The employee has provided to the plan administrator a representation in writing (or, if permitted by the plan,via electronic medium) that he/she has insufficient cash or other liquid assets reasonably available to satisfy the need and the plan administrator does not have actual knowledge to the contrary.
4. Optional conditions a plan sponsor can require include:
a. A requirement that the employee obtain all nontaxable loans under the plan and all other plans maintained by the employer.
b. A representation by the employee that the need cannot be satisfied through reimbursement or compensation by insurance or otherwise.
c. A representation by the employee that the need cannot be satisfied or otherwise liquidating the employee’s assets (if doing so would not itself create a heavy and financial need).
d. A representation by the employee that the need cannot be satisfied by borrowing money from a commercial lender on reasonable commercial terms.
|Under current (pre-2020) regulations, the employee had to be prevented from making salary deferral contributions under a tax-qualified plan for at least six months from the date of the hardship withdrawal. An employee can no longer be automatically prevented from continuing to make salary deferral contributions under a Section 401(k) plan after the withdrawal; nonqualified deferred compensation plans can, however, provide for suspension of deferrals following a hardship withdrawal under a Section 401(k) plan.|
The plan administrator is not required to inquire into the employee’s financial condition; rather, the distribution cannot be made if the plan administrator knows the representation is false.
A plan is permitted to impose a minimum amount eligible for hardship so long as it is nondiscriminatory.
A plan can also require participants to complete an application and provide substantiation.
|Eligible Accounts/Earnings||The following Section 401(k) accounts/amounts are eligible for hardship withdrawal:|
Salary deferral contributions and earnings on those amounts.
Qualified Nonelective Contributions and the earnings on those contributions.
Qualified Matching Contributions and the earnings on those contributions.
401(k) safe harbor nonelective contributions and the earnings on those contributions.
401(k) safe harbor matching contributions and the earnings on those contributions.
|Under the existing (pre-2020) regulations, only earnings on elective deferrals before 1989 are eligible for hardship withdrawal; none of the restricted contribution sources or the earnings on them is eligible. |
A plan does not have to permit hardships from all of these sources and may also exclude earnings from being eligible for withdrawal. Due to the difficulty of tracking the amount of contributions without earnings, most plans that permit hardship withdrawals will likely want to make earnings eligible for withdrawal.
|Substantiation||Despite the new employee representation permitted, the plan administrator should still require substantiation from the employee that a financial need exists. Common examples for the eligible expenses include:|
1. Medical expenses — Explanations of benefits and receipts showing the medical services, the patient, the date of the services, and insurance coverages.
2. Principal residence purchase — contracts for purchase of a house, closing statements, and estimated closing statements.
3. Education expenses — receipts and invoices from schools and other permitted vendors.
4. Eviction/Foreclosure– communications from financial institutions or court notices.
5. Funeral expenses – invoices from funeral homes, cemeteries, etc.
6. Casualty loss to principal residence — receipts and repair estimates.
7. Disaster loss — receipts and repair estimates.
|Even if a plan administrator contracts with the plan record keeper or third party administrator to handle participant hardship withdrawals, the plan administrator is ultimately responsible for the proper administration of the plan and therefore must maintain adequate records in the event the plan is selected for IRS examination. Even though neither the existing nor the new IRS regulations explicitly require substantiation, the IRS has detailed examination guidelines for audits of hardship expenses, including the substantiation of the hardship event.|
Plan administrators cannot simply rely on self-certifications by participants that they have an immediate and heavy financial need.
Action items for Plan Sponsors and Administrators
Given the fast-approaching effective date, plan sponsors and plan administrators will need to review their internal procedures and discuss with their plan recordkeeper and/or third party administrator the changes needed to current procedures and updates to participant disclosures and distribution forms to assure timely compliance with the new rules.
Payroll systems will also need to be reviewed to assure no six-month suspension on making elective deferrals is applied to hardship withdrawals made on or after January 1, 2020. Note, however, the final regulations allow lifting existing deferral suspensions on hardship withdrawals (i.e., suspensions applicable to pre-January 1, 2020 withdrawals) at this time.
Plan documents will also have to be amended, although the deadline for those amendments is not immediate. Until the plan document is amended, we suggest that plan sponsors document in writing the optional provisions of the new rules they desire to implement and administer their plans accordingly. We recommend that clients update and distribute a revised summary plan description (or supplement to their summary plan description) at this time to reflect the hardship provisions selected by the plan sponsor. Doing so will provide appropriate notification to participants and will avoid having to both provide a notice to participants at this time and later revise the summary plan description.
 Plan sponsors could voluntarily elect to apply the provisions of the proposed hardship regulations starting in the 2019 plan year. A discussion of those rules and the action items needed by plan sponsors who did so is beyond the scope of this Benefits Brief.
 Plans maintained on an individually drafted plan document will likely not have to be amended to reflect the new rules before December 31, 2021. Plans maintained on an IRS pre-approved document (i.e., a prototype or volume submitter document) must be amended by December 31, 2021 to reflect these regulations.