IRS Proposed Regulations on Hardship Distributions: What Plan Sponsors and Administrators May Do Now and Must Do Later

Employee Benefits Alert

Firm Alert

Author(s)

The Internal Revenue Service (IRS) has issued proposed amendments to the regulations governing hardship distributions under 401(k) and 403(b) plans. Many plan administrators of 401(k) and 403(b) plans permitting hardship distributions will want to implement some of the changes soon to take advantage of the liberalized hardship distribution standards, and virtually all sponsors of such plans will be required to amend their plans in the not-so-distant future as a result of these changes.

What operational changes may a plan administrator of a 401(k) or 403(b) plan make for hardship distributions?

Safe harbor expenses for a 401(k) or 403(b) plan. A plan administrator of a 401(k) or 403(b) plan may apply the following changes to the list of safe harbor expenses for which a hardship distribution may be made to distributions made on or after January 1, 2018:

  • Hardship distributions may be made on account of casualty losses deductible under Code Section 165 without regard to the changes made, effective as of January 1, 2018, to Code Section 165 by the Tax Cut and Jobs Act, which generally limited the deduction only to losses attributable to a federally declared disaster.
  • Hardship distributions may be made for qualifying medical, educational, and funeral expenses incurred for a “primary beneficiary under the plan.”
  • Hardship distributions may be made on account of expenses incurred as a result of certain disasters as a category of expenses, without the need of an amendment of the plan in connection with a specific disaster.

Safe harbor for determining the necessity of a distribution under a 401(k) or 403(b) plan. A plan administrator of a 401(k) or 403(b) plan may apply the changes to the safe harbor requirements under which a distribution is deemed necessary to satisfy an immediate and heavy financial need to hardship distributions that are outstanding or made on or after January 1, 2019:

  • A plan is no longer required to suspend a participant’s ability to make elective deferral or after-tax contributions to the plan for six months following a hardship distribution and may lift any such suspension in effect for prior hardship distributions. (Note that this change becomes mandatory for distributions made on or after January 1, 2020, as discussed below.)
  • A participant is no longer required to take any available plan loan prior to taking a hardship distribution.

Sources for a hardship distribution from a 401(k) plan. A plan administrator of a 401(k) plan may expand the sources from which a hardship distribution may be taken to include the following for hardship distributions made on or after January 1, 2019:

  • Earnings on elective deferrals;
  • Safe harbor contributions and related earnings;
  • Qualified non-elective contributions (QNECs) and related earnings; and
  • Qualified matching contributions (QMACs) and related earnings.

Sources for a hardship distribution from a 403(b) plan. A plan administrator of a 403(b) plan may expand the sources from which a hardship distribution may be made to include QNEC and QMACS (and related earnings), but only if such contributions are not held in a custodial account, for hardship distributions made on or after January 1, 2019.

What operational changes must a plan administrator of a 401(k) plan or 403(b) plan make for hardship distributions?

Remove six-month suspension. A plan administrator of a 401(k) or 403(b) plan must cease to enforce the six-month suspension of elective deferrals and after-tax contributions for hardship distributions made on or after January 1, 2020.

Replace facts-and-circumstances test with new minimum standard and required employee representation. A plan administrator of a 401(k) or 403(b) plan will no longer be permitted to apply a facts-and-circumstances test for determining whether a distribution is necessary to satisfy an immediate and heavy financial need of a participant. In place of such test, the administrator must apply the following minimum standard:

  • The hardship distribution may not exceed the amount of a participant’s need (including any amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated from the distribution);
  • The participant must have obtained other available distributions under the employer’s plans; and
  • The participant must represent that he or she has insufficient cash or other liquid assets to satisfy the financial need.

A plan administrator may rely on the participant’s representation unless the plan administrator has actual knowledge to the contrary. These changes must be applied to hardship distributions made on or after January 1, 2020. In addition to the above, a plan administrator may impose further standards for hardship distributions, other than any suspension on elective deferrals or after-tax contributions.

When must a plan sponsor amend its 401(k) or 403(b) plan to reflect changes to hardship distributions?

In the preamble to the proposed amendments, the IRS stated that, if the amendments are finalized, plan sponsors of 401(k) and 403(b) plans that permit hardship distributions will need to amend their plans to reflect the required changes by the deadline to amend a disqualifying provision set out in Revenue Procedure 2016-37. For an individually designed non-governmental plan, such deadline is the end of the second calendar year following issuance of a Required Amendments List that includes the change. The Required Amendments List containing these changes will not likely be issued until next year, which would result in a deadline of December 31, 2021. For a pre-approved plan, the deadline is the end of the remedial amendment period covering the changes, which will likely be January 31, 2023. A plan may also be amended under the same deadlines to adopt optional changes made in connection with the proposed amendments that are put into operation in an earlier plan year. Thus, the earliest amendment deadline that is likely to apply to any calendar year plan is December 31, 2021.

If you have any questions about the proposed amendments, please contact one of the attorneys in the Employee Benefits and Executive Compensation Practice Group at Bradley.