On February 23, 2017, the Internal Revenue Service released its Substantiation Guidelines for Safe-Harbor Distributions from Section 401(k) Plans. And on March 7, 2017 they released a similar memorandum regarding section 403(b) plans. These two statements outlined the requirements for safe harbor hardships in an effort to better inform the public about which events allow a plan participant to qualify for such a distribution. They also outlined steps to follow for determining whether or not a participant is eligible for a hardship distribution. Under these regulations, section 403(b) plans are subject to the same rules as the 401(k) guidelines outlined below.
The IRS gives two main steps when determining whether or not a distribution request meets the “immediate and heavy” financial need requirement:
- Determine whether the employer or third-party administrator, prior to making a distribution, obtains: (a) source documents (such as estimates, contracts, bills and statements from third parties); or (b) a summary (in paper, electronic format, or telephone records) of the information contained in source documents.
- If a summary of information on source documents is used, determine whether the employer or third-party administrator provides the employee notifications required on Attachment I prior to making a hardship distribution.
- If the employer or third-party administrator obtains source documents under Step 1(i)(a), review the documents to determine if they substantiate the hardship distribution.
- If the employer or third-party administrator obtains a summary of information on source documents under Step 1(i)(b), review the summary to determine whether it contains the relevant items listed on Attachment I.
- If the notification provided to employees in Step 1(ii) or the information reviewed in Step 2(ii) is incomplete or inconsistent on its face, you may ask for source documents from the employer or third-party administrator to substantiate that a hardship distribution is deemed to be on account of an immediate and heavy financial need.
- If the summary of information reviewed in Step 2(ii) is complete and consistent but you find employees who have received more than 2 hardship distributions in a plan year, then, in the absence of an adequate explanation for the multiple distributions and with managerial approval, you may ask for source documents from the employer or third-party administrator to substantiate the distributions. Examples of an adequate explanation include follow-up medical or funeral expenses or tuition on a quarterly school calendar.
- If a third-party administrator obtains a summary of information contained in source documents under Step 1(i)(b), determine whether the third-party administrator provides a report or other access to data to the employer, at least annually, describing the hardship distributions made during the plan year.
In an article, entitled Do’s and Don’ts of Hardship Distributions, the IRS gives further advice regarding what to do and what not to do when determining hardship eligibility. They first suggest reviewing the terms of hardship distribution outlined in the plan document, including:
- Whether or not the plan allows for hardship distributions
- The procedures the employee must follow to make the distribution request
- The plan’s definition of what qualifies as a hardship
- Any limits to the amount/type of funds eligible for hardship distribution
After taking all necessary precautions to make sure the plan allows for the type of withdrawal being requested, the employee must then make sure the distribution is on account of an “immediate and heavy financial need” as defined under § 1.401(k)-1(d)(3)(iii)(B) of the Income Tax Regulations. The distribution will be considered in compliance with these regulations if it is for one or more of the following:
- Expenses for medical care deductible under section 213(d) for the employee or the employee’s spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan;
- Costs directly related to the purchase of a principal residence;
- Payment of tuition, related educational fees, room and board expenses for up to the next 12 months of post-secondary education for the employee or the employee’s spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan;
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence;
- Payments for burial or funeral expenses for the employee’s deceased parents, spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan; or
- Expenses for the repair of damages to the employee’s principal residence that would qualify for the casualty deduction under section 165,
and the employee has provided written representation that the need cannot be adequately addressed from other sources such as:
- Through reimbursement or compensation by insurance or otherwise;
- By liquidating the employee’s assets;
- By ceasing elective deferrals or employee contributions under the plan; or
- By other distributions or nontaxable loans from plans maintained by the employer or by another employer, or by borrowing from commercial sources on reasonable commercial terms in an amount sufficient to satisfy the need,
or if a need can’t be relieved by one of the actions listed above without increasing the amount of need. For example, a plan loan can’t reasonably relieve the need for funds to purchase a principal residence if the loan would disqualify the employee from obtaining other necessary financing.
Once it has been determined that the plan allows for hardship distributions, and the sources available for distribution have been determined, the following steps should be taken to begin the distribution process:
- Obtain a statement/verification of the employee’s hardship as required by the plan document’s terms
- Determine that the exact nature of the employee’s hardship qualifies for a distribution under the plan
- Document (following plan’s guidelines) that the employee has exhausted all other options outside of the hardship distribution
- Document the employee’s lack of other resources (spousal/minor children’s assets) if applicable
- Make sure the distribution amount does not exceed amount required to satisfy the employee’s immediate financial need (may be adjusted to account for any taxes or penalties at time of distribution)
- Make sure the amount of distribution does not exceed any limits under the plan, and consists only of eligible amounts
- Let the employee know if receival of the distribution will suspend them from making contributions to the plan for at least six months
If your plan is not properly making hardship distributions, go here to correct any mistakes: https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-hardship-distributions-were-not-made-properly
The IRS also released a list of responses to some FAQs regarding hardship withdrawals, such as:
- What is the maximum amount of elective contributions that can be distributed as a hardship distribution from a 401(k) plan?
- Cannot be more than the amount of the employee’s total elective contributions, including designated Roth contributions, as of the date of distribution reduced by the amount of previous distributions of elective contributions
- Generally does not include earnings, qualified non-elective contributions, or qualified matching contributions unless the plan specifically allows for certain grandfathered amounts to be included
- If provided by the plan, other amounts such as regular matching contributions and discretionary profit-sharing contributions can also be distributed in times of hardship
- What are the consequences of taking a hardship distribution of elective contributions from a 401(k) plan?
- Hardship distributions are eligible to be included in gross income (unless they consist of designated Roth contributions) and may be subject to additional taxes on early distributions of elective contributions
- Unlike loans, hardship distributions are not repaid to the plan, so they will result in a permanent reduction in the employee’s account balance under the plan
- A hardship distribution cannot be rolled over into an IRA or other qualified plan (§ 402(c)(4))
- Hardship distributions may be subject to the 10% early distribution tax on distributions made prior to reaching age 59 ½
- Are hardship distributions allowed from an IRA?
- There is generally no limit when an IRA owner may take a distribution from his/her IRA, but there may be unfavorable tax consequences including an additional tax on early distributions
- Certain distributions from an IRA that are used for expenses similar to those that may be eligible for hardship distributions from a retirement plan are exempt from the additional tax on early distributions
- Any distribution from an IRA for higher education expenses or to finance a first-time home purchase is exempt from the early distribution tax (§ 72(t)(2)(E),(F))
In its Substantiation Guidelines for Safe-Harbor Distributions from Section 401(k) Plans, the IRS also gave a more detailed outline of the types of documentation required for each hardship distribution:
- Notifications the Employer/Administrator must provide to the employee:
- Notification that the distribution is taxable, and additional taxes could apply
- The distribution amount cannot be more than the amount required to solve the “immediate and heavy financial need”
- Earnings on elective contributions from QNEC or QMAC accounts are not eligible for hardship distribution
- The recipient must preserve all source documents and make them available at any time, upon request, to the employer or administrator
- General information required for a hardship request:
- Participant name
- Total cost of the event causing hardship
- Amount of distribution being requested
- Certification (provided by participant) that all information provided is true and accurate
- Specific information required on deemed hardships
- Medical care:
- Name of individual who incurred the medical expenses
- Above’s relationship to the participant
- The purpose of medical care provided
- Name and address of service provider
- Total cost of medical expenses not covered by insurance
- Purchase of principal residence:
- Will this be the participant’s principal residence?
- Residence address
- Purchase price
- Types of costs/expenses covered by withdrawal (down-payment, closing costs, and/or title fees)
- Name and address of lender
- Purchase/sale agreement date
- Date of closing
- Educational payments:
- Name of individual on whose behalf the payments are being made
- Above individual’s relationship to the participant
- Name and address of educational institution
- Categories of payments involved
- Period covered by the educational payments (beginning and end dates of up to 12 months)
- Foreclosure/eviction from principal residence:
- Is this the participant’s principal residence?
- Residence address
- Is this a foreclosure or eviction?
- Name and address of party that issued foreclosure/eviction notice
- Date of foreclosure/eviction notice
- Payment due date in order to avoid foreclosure/eviction
- Funeral and burial expenses:
- Name of deceased
- Relationship to participant
- Date of death
- Name and address of service provider (funeral home, cemetery, etc.)
- Damage repairs to principal residence:
- Is this the principal residence of the participant?
- Address of residence that sustained damage
- Description of cause of damage, including date of the casualty loss
- Describe repairs required, including date(s) of repair (whether still in progress or already completed)
Lastly, in their 401(k) Plan Fix-It Guide: Hardship distributions weren’t made properly article, the IRS also gave some helpful pointers in determining whether or not a company’s hardship distribution program is being abused or poorly managed. The first warning sign is that too many hardship requests are being made by one group or division; the second is that requests for distributions from multiple employees appear identical, because each situation should have its own individual circumstances; the third and last warning that they offer is to beware of instances where only the highly compensated employees have hardship distributions, because this may be a sign that the rank-and-file employees have not been properly notified of the availability of hardship distributions under their plan.