Retirement plans are permitted, but not required, to provide in-service distributions of elective deferrals to participants if they can show financial hardship, which is defined as a hardship that is “deemed to be on account of an immediate and heavy financial need.” The IRS delivered good news earlier this year for those needing to demonstrate such a hardship, when it issued its Memorandum for Employee Plans Examination Employees (EP Memorandum). The memo indicates that participants no longer need to provide source documents to show their financial hardship, and that plan sponsors may instead rely on participant-provided summaries as long as the participants agree to retain any source documents.
Types Of Hardship Distributions
IRS regulations provide six safe harbor events that qualify as demonstrating immediate and heavy financial need. Plans can provide for hardship distributions for events outside of the six safe harbors, but only limited guidance exists as to what else qualifies, and the agency has said such circumstances will be determined on a case-by-case basis. The six safe harbors are:
- Expenses for tax deductible medical care previously incurred by the participant, the participant’s spouse, or any of the participant’s dependents;
- Costs directly related to the participant’s purchase of a principal residence;
- Payments of tuition, related educational fees, and room and board expenses for the next 12 months of post-secondary education for the participant, the participant’s spouse, or the participant’s children or dependents;
- Payments necessary to prevent the participant’s eviction from the participant’s principal residence or foreclosure on the mortgage on that residence;
- Payments for burial or funeral expenses for the employee’s deceased parent, spouse, child, or dependent; and
- Expenses for the repair of damage to the employee’s principal residence that would qualify as a casualty tax deduction.
Hardship Distributions And Source Documents
In April 2015, the IRS issued an Employee Plans newsletter indicating that it was impermissible for plan sponsors to grant hardship distribution requests based upon participant certifications. Instead, the newsletter indicated that plan sponsors should request and retain source documentation to show the nature of the hardship. This was important because failure to have hardship distribution records during an audit is considered a plan qualification issue and could lead to negative consequences.
The IRS did permit plan sponsors to rely on a participant’s certification that a hardship distribution was the only way to alleviate the immediate and heavy financial need. For example, if a participant requests a hardship distribution to prevent eviction, the employee would have to provide source documentation such as an eviction letter from the landlord, but the plan sponsor could rely on a statement saying that the participant had an immediate and heavy financial need.
EP Memorandum Examination Standard
According to the recently issued EP Memorandum, IRS auditors should review whether the plan sponsor obtains source documents or summaries of information that would be found in such documents. If the plan sponsor only requests summaries, it also must send a notification to the participant requesting the distribution stating that hardship distributions are taxable and additional taxes may apply, the amount of the distribution cannot be more than the amount of immediate and heavy financial need, and that the distributions cannot be made from qualified non-elective contributions or qualified matching contributions. It must also indicate that the requesting participant promises to keep the source documents available to be produced upon the plan sponsor’s request.
Generally, the participant summary should include the same information that the source documents would provide. For example, instead of providing an eviction letter, the plan sponsor could provide the examiner with a participant summary which includes the amount of the distribution request, a statement that the purpose of the distribution is to avoid eviction from the principal residence (including the address), detail about the eviction (date of eviction notice, payment due date, and contact information for the landlord), as well as a certification from the participant that this information is true and accurate.
While the EP Memorandum is not a formal IRS regulation, it does reflect how the IRS will approach hardship distribution documentation in a plan audit. Accordingly, plan sponsors may now consider revising their procedures to grant hardship distributions based upon participant summaries, provided the other requirements described above are satisfied. Plan sponsors will still need to keep records of the summaries, but will not necessarily need to scrutinize source documents.