Are You Keeping the Right Documentation for 401(k) Hardship Distributions?

401(k) plans may allow an employee to receive a distribution of elective contributions (employee deferrals) on account of a hardship. The regulations provide that a distribution is made on account of hardship only if the distribution is made on account of an employee’s immediate and heavy financial need and is necessary to satisfy the financial need. The regulations provide that certain safe harbor distributions will be deemed to meet the “immediate and heavy financial need” requirement (for example, deductible medical expenses); however, plans are required to substantiate that the distribution meets the requirements for the specific type of safe harbor distribution.

The regulations do not provide much guidance on what is required for substantiation. In the past, the Internal Revenue Service (IRS) has issued informal guidance in its Employee Plans News publications in 2009 and 2015. It has also provided tips for an Employee Plans (EP) exam on the IRS website. However, the prior guidance, while helpful, has not been extensive. Recently, the Acting Director of EP Examinations issued a memorandum to its employees regarding substantiation guidelines for safe harbor distributions. While the memorandum is not legally binding, it does provide very helpful insight into what plans should do to meet the substantiation requirements, and it will, as a practical matter, be helpful in the event of an audit.

The memorandum directs EP employees conducting an examination to look for two things. First, EP employees are directed to obtain “source documents” such as “estimates, contracts, bills and statements from third parties.” Second, EP employees are directed to obtain a summary of the information contained in the source documents. The summary should include certain notifications made to the employee before the hardship, as follows:

• The hardship distribution is taxable and additional taxes could apply.
• The amount of the distribution cannot exceed the immediate and heavy financial need.
• Hardship distributions cannot be made from earnings on elective contributions or from qualified nonelective or matching contributions, if applicable.
• The recipient agrees to preserve source documents and to make them available at any time, upon request, to the employer or administrator.

The memorandum then directs the EP employee to take further action if the notifications are incomplete (such as requesting source documents) or if there are more than two hardship distributions in a year. The memorandum is particularly helpful in setting forth very specific information that the EP employee should look for in the source documents. For example, for distributions necessary to prevent foreclosure or eviction, the following specific information should be requested:

• Is this the participant’s principal residence?
• Address of the residence
• Type of event (foreclosure or eviction)
• Name and address of the party that issued the foreclosure or eviction notice
• Date of the notice of foreclosure or eviction
• Due date of the payment to avoid foreclosure or eviction

Employers and third-party administrators who assist with plan administration should take note of the specific lists in the memorandum for each type of safe harbor distribution.

If you have any questions about hardship distributions or other employee benefits matters, please contact one of the attorneys in the Employee Benefits & Executive Compensation Group at Bradley.