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What employers need to know to implement the new hardship withdrawal regulations

Lori Jones February 20, 2019

This article originally appeared in the January 2019 issue of Employee Benefit Plan Review.

The Bipartisan Budget Act of 2018 (“BBA”)[1] significantly changes the rules for hardship withdrawals from Section 401(k) and Section 403(b) plans as follows:

  • The Secretary of the Treasury must revise Treasury Regulations to delete the six-month suspension of elective deferral contributions[2] with respect to a participant receiving a hardship withdrawal.

  • A distribution will not fail to qualify as a hardship withdrawal merely because a plan participant does not first take all available loans under the plan and all other plans maintained by the employer.[3]

  • The portion of a participant’s account from which hardship withdrawals can be taken is expanded to include the earnings on elective deferral contributions, as well as qualified non-elective contributions (QNECs), qualified matching contributions (QMACs), and the earnings thereon.[4] In addition, because Treasury Regulations define QNECs and QMACs to include nonelective and matching contributions that are subject to the vesting and withdrawal restrictions under Section 401(k)[5] hardship withdrawals may now be made from safe harbor matching contributions and safe harbor nonelective contributions under a safe harbor 401(k) plan.

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Proposed regulations on hardship withdrawals

On November 14, 2018, the Treasury Department published proposed regulations that provide guidance with respect to the changes made by the BBA.[6] Employers may rely on the proposed regulations pending the issuance of final regulations.[7]

Deletion of six-month suspension of elective deferral contributions after hardship withdrawal

The proposed regulations provide that, in light of the delay in publication of the proposed regulations, the deletion of the six-month suspension of elective deferral contributions is mandatory only with respect to hardship withdrawals made on or after January 1, 2020. However, plans may elect to provide for the deletion of the suspension rule as early as the first day of the first plan year beginning after December 31, 2018. This is true even for hardship withdrawals made prior to 2019. For example, a calendar year plan may be amended to provide that elective deferral contributions will not be suspended after January 1, 2019 with respect to hardship withdrawals granted in the latter half of 2018.

Establishing financial need for a hardship withdrawal

Effective for hardship withdrawals made on or after December 31, 2018, the proposed regulations eliminate the mandatory requirement that a participant obtain all loans available under the plan and all other plans maintained by the employer. Such a restriction is now an optional provision that may be adopted by the employer. The requirement that a participant must first obtain available distributions under all other plans maintained by the employer, (whether qualified or nonqualified) before receiving a hardship withdrawal remains in place.

In addition, for hardship withdrawals on or after January 1, 2020, a participant must represent to the employer in writing that he or she has insufficient cash or other liquid assets to satisfy his or her financial need.[8]

Sources of hardship withdrawals

The preamble to the proposed regulations states that, although plans are now permitted to make hardship withdrawals from earnings on elective deferral contributions, as well as QNECs, QMACs, and the earnings thereon, an employer may choose whether to limit the type of contributions available for hardship withdrawals. For example, an employer may decide that employer contributions will not be available for hardship withdrawals.

Safe harbor hardship expenses

The proposed regulations add the following new category to the list of safe harbor expenses and losses deemed to be an immediate and heavy financial need: expenses and losses (including loss of income) incurred as a result of a federally declared disaster. To qualify for a hardship withdrawal, a participant’s principal residence or principal place of employment must be located in the designated disaster at the time of the disaster.[9] This change is similar to relief granted by the IRS after recent hurricanes and wildfires and is intended to facilitate a participant’s access to his or her plan account following such a disaster.

In addition, the proposed regulations fix a glitch caused by the Tax Cuts and Jobs Act of 2017, which inadvertently required that a casualty loss be incurred in a federally declared disaster to be eligible for a hardship withdrawal. The proposed regulations clarify that expenses for the repair of damage to a participant’s principal residence, which would qualify as a casualty loss deduction under Internal Revenue Code Section 165, will be deemed an immediate and heavy financial need for purposes of the hardship withdrawal rules whether or not the casualty loss is attributable to a federally declared disaster.

The proposed regulations indicate that these revisions to the list of safe harbor hardship expenses may be effective as early as the first day of the 2018 plan year, if plan amendments so provide.

Finally, the proposed regulations incorporate guidance provided under the Pension Protection Act of 2006[10] and Notice 2007-07[11] by providing that qualifying medical, educational, and funeral expenses relating to a participant’s primary beneficiary may qualify as expenses eligible for a hardship withdrawal.

403(b) plans

The above description of the proposed regulations also applies to Section 403(b) plans with two important exceptions. First, whether intended or due to oversight, the BBA did not expand the portion of a participant’s 403(b) account from which hardship withdrawals can be taken to include earnings on elective deferrals contributions. Second, QNECs and QMACs in a Section 403(b) plan that are in a custodial account continue to be an ineligible source of hardship withdrawals.

Next steps

The changes made by the BBA and the proposed regulations require employers to undertake a review of plan provisions relating to hardship withdrawals. The review should include the following steps:

  • Discretionary provisions – Employers will need to consider the following questions with respect to discretionary provisions:

    • Should the plan delete the six-month suspension provisions for hardship withdrawals issued before January 1, 2020? According to the IRS, failures with respect to the suspension of elective deferral contributions is one of the most common errors with respect to the administration of hardship withdrawals.[12] That being the case, it seems logical for employers to implement this change, effective January 1, 2019.

    • Should the plan continue to require a participant to obtain all available plan loans before granting a hardship withdrawal? Eliminating the loan requirement is another opportunity to simplify plan administration and avoid administrative errors, e.g., errors that occur if an employer fails to accurately track outstanding plan loans. On the other hand, unlike hardship withdrawals, loans are not subject to the early distribution excise tax under Internal Revenue Code Section 72(t).[13]

    • Should the plan expand the portion of a participant’s account from which hardship withdrawals can be made? This decision requires an employer to consider its goals in maintaining the plan. Some employers may feel that hardship withdrawals should be limited in order to preserve the retirement benefits of participants. Others might argue that the categories of expenses that qualify as deemed immediate and heavy financial needs provide sufficient protection against the frivolous erosion of a participant’s retirement nest egg.

    • When should the changes to the list of safe harbor expenses be effective? Presumably, most employers will amend their plans to add the new category of eligible expenses and losses related to a federally declared disaster since the precipitating event will be independently verified by a federal agency. However, employers must decide whether to make these changes retroactive to January 1, 2018. For example, employers impacted by Hurricane Florence may decide to adopt a 2018 effective date.
  • Plan amendments – The proposed regulations provide that amendments to reflect the proposed regulations need not be made until the end of the second calendar year beginning after the issuance of the Required Amendments List issued by the IRS. However, employers may wish to adopt plan amendment sooner to ensure proper plan administration. In addition, if hardship withdrawals were granted on or after January 1, 2018 without regard to the Tax Cuts and Jobs Act of 2017, i.e., for casualty losses not attributable to a federally declared disaster, the plan amendment should be adopted before the end of the 2018 plan year.

  • Participant communications – Participants should be advised of the changes to the hardship withdrawal requirements under the plan via a revised summary plan description (SPD) or a summary of material modifications to the SPD. If the requirement to first obtain plan loans is eliminated from a plan, employers may also wish to educate participants on the possible advantages of loans, e.g., loan interest paid by a participant is credited to his or her account.

  • Hardship withdrawal procedures – Hardship withdrawal procedures should be updated, effective January 1, 2020, to require a participant to provide a representation in writing that he or she has insufficient cash or other liquid assets to satisfy his or her financial need. An employer may rely on such representation unless it has actual knowledge to the contrary.

  • Documentation of hardship withdrawals – Although not changed by the BBA or the proposed regulations, an employer should also take this opportunity to review its process for documenting hardship withdrawals. The IRS has warned employers that they, and not third party administrators, are responsible for the recordkeeping for hardship withdrawals. On its website, the IRS highlights two methods for substantiating hardship withdrawals.[14] Under the transitional substantiation method, an employer must retain the following records in paper or electronic format:

    • Documentation of the hardship request, review and approval;

    • Financial information and documentation that substantiates the employee’s immediate and heavy financial need;

    • Documentation to support that the hardship withdrawal was properly made in accordance with the applicable plan provisions and the Internal Revenue Code; and

    • Proof of the actual distribution made and related Forms 1099-R.[15]
    The alternative “summary substantiation method” is available for the categories of hardship withdrawals that are deemed to constitute an immediate and heavy financial need. See Internal Revenue Manual (IRM) Section 4.72.2.7.4.1 (09-05-2017), and Exhibit 4.72.2-2, Attachment One Hardship Substantiation Information and Notifications for Summary of Source Documents.

Conclusion

The changes relating to hardship withdrawals under the BBA and the corresponding proposed regulations generally make it easier for participants to obtain hardship withdrawals from a Section 401(k) plan or Section 403(b) plan. In implementing these changes, employers will need to balance the short-term financial needs of participants against the long-term goal of providing retirement security.

Lori Jones is the chair of Thompson Coburn’s Employee Benefits practice.

[1] Pub. L. 115-123.

[2] Bipartisan Budget Act of 2018, Section 41113

[3] BBA, Section 41114.

[4] Id.

[5] Treasury Regulation Section 1.401(k)-6.

[6] https://federal register.gov/d/2018-24812

[7] Although not explicitly stated, employers can infer from the extensive discussion of applicability dates under the heading “Applicability Dates and Reliance,” which includes some dates retroactive to January 1, 2018, that they can rely on the proposed regulations until final regulations are issued.

[8] Prop. Treas. Reg Section 1.401(k)-1(d)(3)(iii)(B).

[9] Prop. Treas. Reg. Section 1.402(k)-1(d)(3)(ii)(B)(7)

[10] Section 826, Pub. L. 109-280.

[11] 2007-5 I.R.B. 395.

[12] https://www.irs.gov/retirement-plans/correct-common-hardship-distribution-errors

[13] Section 72(t).

[14] https://www.irs.gov/retirement-plans/its-up-to-plan-sponsors-to-track-loans-hardship-distributions.

[15] https://www.irs.gov/retirement-plans/its-up-to-plan-sponsors-to-track-loans-hardship-distributions.