What is the IRS thinking about when it announces that plan sponsors, even those using a qualified TPA/recordkeeper, should maintain the records for hardship distributions and participant loans?

401(k) plans particularly (although this applies to other types of qualified plans that permit participant loans) have been marketed and promoted to would-be participants as flexible retirement saving arrangements – so flexible that you can take your money back out without a problem either by borrowing it or by taking a hardship distribution. Depending on your perspective, this flexibility may be anathema to the notion of retirement savings, i.e., long-term savings and investing.   America’s 401(k) saving structure is, in this respect, more “flexible” than arrangements in most other countries that have similar plan structures. The unfortunate result of this sort of flexibility is “leakage” – about which officials at Treasury and Labor seem concerned.

So, to beg the obvious question, did the IRS issue this “reminder” to plan sponsors because of its disdain for leakage? In view of the fact that the pronouncement tends to ignore how most 401(k) plans actually operate, one might certainly come to that conclusion.

The IRS says that, for hardship distributions, the plan sponsor (not its TPA) should retain these 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 distribution was properly made in accordance with the applicable plan provisions and the Internal Revenue Code
    • Proof of the actual distribution made and related Forms 1099-R

Fidelity came out of the box swinging. In a public reaction to the pronouncement on hardship distribution record requirements, Fidelity begins by saying, “Fidelity offers a hardship withdrawal distribution procedure that does not require that a participant submit supporting documentation.” Fidelity then describes how its electronic system works and how it is compliant with the law. Fidelity also criticizes gaps in the law. And well it should since the guidance out there makes electronic processing of hardship distributions as described by Fidelity proper. But, of course, this begs other questions – shouldn’t the plan sponsor be able to rely on Fidelity and the other capable recordkeepers, and do plan sponsors really have to have all of the documentation the IRS describes?

On the participant loan front, the IRS states that the plan sponsor “should” retain these records either on paper or electronically:

  • Evidence of the loan application, review and approval process
  • An executed plan loan note
  • If applicable, documentation verifying that the loan proceeds were used to purchase or construct a primary residence
  • Evidence of loan repayments
    • Evidence of collection activities associated with loans in default and the related Forms 1099-R, if applicable

There are some other documentary requirements if the participant seeks a loan “in excess of five years” (hmm, not “within” five years) for the purchase or construction of a primary residence.

In an effort to honor the flexibility that Congress has granted to 401(k) plans, plan loan processes are mostly electronic and are designed to follow the requirements of Code section 72(p) without the complexity of all of the now seemingly required documentation. Of course, evidence of an obligation to pay can take a form other than a plan loan note, and most e-systems do not automatically generate a note, but instead, a note may be generated if desired by the participant.

The IRS in the recent past has been pushing for plans to utilize good internal controls. Apparently, reliance on your TPA no matter how competent and no matter how good its systems is not a satisfactory internal control and is inadequate when it comes to leakage. Let’s assume that this required documentation is plan documentation and that the plan sponsor is obligated to maintain it without reliance on a recordkeeper. So, what’s a plan sponsor to do?

At the present time, it may be impossible for many recordkeepers to “transfer” the hardship and loan documentation in electronic format to the plan sponsor. But every plan sponsor should probably request it from the recordkeeper and request that the electronic data be transmitted to the plan sponsor with each future hardship distribution and each participant loan. And, then, of course, there’s the fiduciary obligation to review the information and make certain of compliance with the rules since the plan sponsor may not be able to rely on the recordkeeper to do that. And failing or refusing to do this, maybe the IRS’s real objective will be met – the plan will be amended to eliminate participant loans and hardship distributions in order to avoid leakage.