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DO YOU SEE WHAT I SEE? HARDSHIP WITHDRAWAL GUIDANCE FROM THE IRS, AS REQUESTED BY CONGRESS

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This time of year, gift-givers may feel rich in spirit but otherwise penniless. They may ask whether they can receive a hardship distribution from their 401(k) account when faced with a not-so-holly or jolly bank statement at the end of December. Those of us who work with 401(k) plans know, however, that it takes more than a large credit card bill to justify a participant’s request for a hardship distribution. Generally, the federal tax code restricts a participant’s access to a 401(k) account balance so that such benefits can provide retirement income, not replenishment of a checking account. More specifically, federal tax rules permit a hardship distribution only if (a) the participant experiences an “immediate and heavy financial need” and (b) the distribution is no greater than the amount “necessary to satisfy the financial need.” In turn, Treasury regulations provide that hardship withdrawals on 401 (k) balances are available for participants who satisfy any of 6 safe harbors or a general, catch-all provision.

Additional requirements have historically applied. In order to be eligible for a hardship distribution, a participant, also, was required to have taken out all available plan loans, and after a hardship distribution was granted, the participant could not make 401(k) salary deferral contributions for six months afterwards. Although these rules sought to ensure that a hardship withdrawal was a distribution of last resort, some felt that they were unduly restrictive. For instance, an argument can be made that, by requiring a participant first to take out plan loans and to sit out of 401(k) contributions for six months, the rules interfered with participants rebuilding their account balance – thus worsening the very ills the rules sought to prevent. Over the summer, Congress responded to these concerns in the Bipartisan Budget Act of the 2018 (“2018 Act”), and as discussed in a previous blog post, changed some of those rules. On November 14, 2018, the IRS issued proposed regulations reflecting the changes made in the 2018 Act. Although the regulations will not be finalized until 2019 at the earliest, some of the new rules can be implemented earlier than that. Read on for details as to what – and when – changes are required and/or permissible as stated in the proposed regulations.

Optional for Hardship Distributions Made as Early as January 1, 2018; Otherwise, Generally Applicable for the First Plan Year Beginning after December 31, 2018:

  • In our earlier article, we told you about what appeared to be an inadvertent change narrowing the scope of one safe harbor withdrawal distribution. The proposed regulations reverse that change: hardship withdrawals for expenses to repair property damage to a participant’s home that would qualify for a casualty deduction under Section 165 of the federal tax code may be appropriately considered a hardship withdrawal, even if the property damage was not the result of a federally-declared disaster. A plan is not required to make this change for 2018.
  • The proposed regulations add a new safe harbor that permits a hardship withdrawal to pay for a participant’s expenses or losses (including loss of income) to repair a participant’s principal home or place of business located within an area designated by Federal Emergency Management Agency (“FEMA”) to be eligible for assistance because of a federally-declared disaster. Typically, the IRS issues special relief after (and restricted to) a particular disaster; this change increases the certainty and speed with which participants have access to hardship withdrawals.
  • The proposed regulations incorporate guidance previously provided in IRS Notice 2007-7 to permit a hardship withdrawal if the distribution is needed for qualifying medical, educational, and/or funeral expenses incurred for the “primary beneficiary,” i.e., someone who is named as the participant’s beneficiary and who has an unconditional right to benefits upon the participant’s death. This proposed provision is less restrictive. Previously, such expenses were required to be incurred for a participant or a participant’s spouse or child.

Permitted for the First Plan Year Beginning after December 31, 2018 (Even for Distributions in 2018); Mandatory for Hardship Distributions Made on or after January 1, 2020:

  • Beginning with the 2019 Plan Year, a plan sponsor can choose whether to remove the requirement that a participant suspend employee contributions (whether pre- or post-tax and including Roth) to employer-sponsored plans for 6 months after receiving a hardship withdrawal. Moreover, a plan sponsor can choose to implement this change such that a participant who took a hardship withdrawal in 2018 may be suspended for a period of less than six months. For instance, suppose a participant’s six-month suspension begins as of October 1, 2018; under the new rule, a plan may end the suspension effective as of January 1, 2019. Alternatively, a plan sponsor may choose to implement this beginning with hardship distributions made in 2019. Either way, under the proposed regulations, this change will be mandatory effective as of January 1, 2020.

Permitted Beginning with Hardship Distributions Made in the First Plan Year Beginning after December 31, 2018:

  • A plan sponsor may choose to eliminate the requirement that a participant take all available plan loans prior to being eligible for a hardship withdrawal. Alternatively, a plan sponsor may retain the requirement; the change is optional.
  • A plan sponsor may choose whether to permit hardship withdrawals from a broader range of contribution sources, including qualified nonelective contributions (“QNECs”), qualified matching contributions (“QMACs”), and earnings on these amounts or on elective deferral contributions. Note that, because safe harbor contributions are subject to the same distribution limitations as QNECs or QMACs, they can also be available for hardship withdrawal distributions if a plan sponsor so chooses. Alternatively, a plan sponsor may retain the current rule that limits the source of funds for a hardship distribution.
  • The proposed regulations would eliminate the current facts-and-circumstances rule that applies in determining whether a distribution is necessary to satisfy a financial need. In its place will be a new, objective standard that requires:
    • the distribution amount may not exceed the employee’s need (plus amounts to pay necessary federal, state, or local income taxes or penalties that are reasonably anticipated to apply because of the distribution), and
    • the participant must have obtained all other currently available distributions under this or any other plan sponsored by the employer.

Effective for hardship distributions made on or after January 1, 2020, the participant will be required to represent in writing that he or she has insufficient cash or other liquid assets to satisfy the financial need. The plan administrator will be able to rely on the participant’s written representation so long as the plan administrator does not have actual knowledge to the contrary.

Changes to Plan Documents

The proposed regulations note that plan amendments will be necessary to reflect these changes once final regulations are issued, but states that such amendments will have a deadline that is tied to the Required Amendments List published by the IRS. In other words, the IRS notes in its preamble that the normal rule for determining the deadline for a disqualifying provision applies. Therefore, it is expected that an individually designed plan will be considered timely amended so long as the plan is amended no later than the end of the second calendar year that begins after issuance of the Required Amendments List that includes these changes.

Changes in Plan Administration

When it comes to plan administration, time is of the essence. Plan sponsors should review their hardship distribution procedures and identify the appropriate effective date for the changes that are mandatory, as well as the optional changes they wish to implement. Plan administrators must evaluate how their hardship distribution forms, participant communications, and operational procedures must be revised to implement such changes, and then accomplish those changes on time. A plan sponsor whose plan is on a pre-approved platform (previously referred to as “prototype” or “volume submitter” documents) should talk with their document provider to understand what options are available to them and choose accordingly.

If you have questions about how these changes apply to your plan, or how to comply with these changes, contact experienced benefits counsel who can review your plan terms with you. 

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