Plan Sponsors Need to Understand the Hardship Rules
A 401(k) plan may allow participants who face certain types of financial stress or emergencies to request a distribution from their account balance. Allowing hardship distributions from your 401(k) may in fact be a plan feature that benefits certain participants who are financially distressed yet puts an added burden on plan sponsors to understand and properly implement IRS regulations. Failure to do so may subject them to severe consequences, including fines, penalties and plan disqualification.
In November of 2018, the IRS proposed changes to hardship distributions, including how and under what circumstances they could be received by participants. Beginning in January of 2019, employers were allowed to implement certain of these changes prior to them becoming finalized by the IRS.
Since I am frequently asked questions regarding hardship distributions by plan sponsors, we thought it might be helpful to review some of the most FAQ’s regarding these often misunderstood guidelines.
Are all 401(k) plans required to permit hardship distributions?
No. The decision to allow hardship distributions is an option available either when the plan is originally established or as an amendment to an existing plan. Keep in mind that individual plan demographics may work against allowing this feature if a higher percentage of participants may find themselves qualifying for these distributions.
What are the qualifications for a participant to request hardship distributions?
A 401(k) participant must satisfy two criteria in order to qualify for a hardship distribution:
- He or she must have an “immediate and heavy financial need”.
- The distribution should be “limited to an amount necessary to satisfy that need”.
What is the IRS definition of hardship for a 401(k) plan?
In addition to the employee’s immediate and heavy financial need, the definition includes those of an employee’s spouse, dependents and beneficiaries. Employers are allowed determine certain qualifying events of hardship under two options:
- Use the IRS Safe Harbor definition.
- Use a custom definition.
In the great majority of cases, plan sponsors elect to use the Safe Harbor option which lays out 6 events which qualify as a participant hardship:
- Medical care for the employee, the employee’s spouse, dependent or beneficiary.
- Direct costs related to the purchase of an employee’s personal residence, not including the mortgage.
- Tuition, fees and room and board expenses for the next 12 months of post secondary education for an employee, an employee’s spouse, dependent or beneficiary.
- Payment necessary to prevent eviction or foreclosure on a participant’s primary residence.
- Funeral expenses for the employee, employee’s spouse, dependent or beneficiary.
- Certain expenses to repair damage to an employee’s permanent residence.
How do we calculate the amount necessary to satisfy the immediate financial need?
The IRS regulations make it clear that the distribution may factor in the impact of taxes and penalties that may result from qualified hardship distributions. In addition, employers should make the determination that the employee could not reasonably obtain liquid funds from any other source.
In addition, employers are allowed rely on the employee’s written statement that the need cannot be relieved from other resources, including insurance or other reimbursements, liquidation of the employee’s assets, the employee’s wages after termination of all elective deferrals and plan or “reasonable” commercial loans.
What documentation should employers obtain as part of the hardship distribution application?
Employers are allowed to choose one of two options in regard to the proper documentation of all plan hardship distributions:
- Traditional Substantiation:
Under this method, employers obtain the actual source documentsthat substantiate the need. This is the only method that is acceptable for non-safe harbor hardship qualification.
- Summary Substantiation:
Employers rely on a written, participant-provided summaryof the hardship, provided that the summary includes certain, required information.
In every case, plan sponsors should retain these documents according to the document retention rules established under ERISA.
What are the financial consequences of hardship distributions on participants?
Hardship distributions can have severe and significant financial impacts upon participants in that they are included in gross income unless they consist of designated Roth contributions. Participants who have not yet attained the age of 59 ½ are subject to additional penalties of 10%. Finally, because hardship distributions cannot be repaid to the plan or rolled into another qualified plan, the compounding impact of future lost income due to these withdrawals can be significant.
What are the IRS proposed rule changes to hardship distribution regulations?
The IRS implemented a number of significant changes to the current hardship regulations and issued a proposal draft in November of 2018 outlining the changes. Plan sponsors were allowed to implement these changes on January 1, 2019 or alternatively, they may choose to wait until the changes are finalized.
The key changes in the current proposal are as follows:
- Removal of the six month suspension rule following a participant distribution. Under current rules, participants are prevented from making contributions to the plan for a 6 month period. Employers have the option in 2019 to remove this suspension and are mandated to do so beginning January 1, 2020.
- Current regulations limit the source of contributions eligible for distributions, excluding QNEC’s, QMAC’s, safe harbor contributions and earnings on elective deferrals. The new proposal lifts these restrictions. Implementation is optional, not mandatory.
- Under current standards, participants are required to take a loan prior to requesting a distribution. The proposal eliminates this provision.
- Employers currently must consider all relevant facts and seek relevant documentation. The proposal allows them to rely on written representations from participants that he/she has sufficient liquid assets to satisfy the need, unless the employer has knowledge to the contrary.
- An additional qualifying event – expenses resulting from federally declared disasters– has been added to the safe harbor list of qualifying events.
What is the deadline for making plan changes based on the current proposed changes?
Employers can elect to rely on the proposed changes beginning this year prior to a formal plan amendment. However, the Treasury Department and the IRS expect that, if these regulations are finalized as proposed, plan sponsors will need to amend their plan’s hardship distribution provisions. As of this writing, the guidance is that most amendments will need to be made within the period ending the second year following the year that the rules have been finalized. (See section “Plan Amendments” in IRS Proposed Rule for details.)
In the interim, plan sponsors should consult their providers for guidance on implementation of these new proposed rules.
Concluding Thoughts for Plan Sponsors:
Hardship distribution provisions in 401(k) plans provide a valuable benefit to participants who may be experiencing temporary financial stress due to certain qualifying circumstances and to employers who may lose productivity from these employees. However, they put additional burdens on plan sponsors to properly understand the rules and have a process in place to implement their requirements. Best practices include proper documentation and retention for each request as well as full disclosure of the financial consequences to participants. Your plan providers should be consulted prior to giving specific guidance as they may require specific forms and disclosure documents that apply.
Plan sponsors electing to amend their plans to allow hardship withdrawals must do so during the current plan year and disclose the details of this change to participants by December 1 to have the changes take effect in the next plan year.
Brian C. Rall
President – Strategic Retirement Partners, LLC
Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education to company sponsored retirement plans.
Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.