In a recent Employee Plans Newsletter, the Internal Revenue Service (IRS) warned plan sponsors that they must obtain and keep documentation related to hardship withdrawals, particularly the documentation necessary to substantiate an employee’s immediate and heavy need for a hardship withdrawal. In its view, an electronic hardship withdrawal application process in which the employee “self-certifies” that he or she has an immediate and heavy financial need without providing back-up documentation will not serve as sufficient proof of a proper hardship withdrawal in the event of a plan audit.
The Internal Revenue Code and applicable Treasury Regulations provide that employees may take hardship withdrawals only upon a showing of immediate and heavy financial need that cannot be met from other sources. Formal guidance is silent on exactly what type of proof an employee must provide, and what type of documentation the plan sponsor must keep on file regarding eligibility for a hardship withdrawal.
As a result, several third-party administrators have developed an entirely electronic hardship withdrawal application process, through which employees enter information about a particular financial need (e.g., medical expenses, tuition, pending foreclosure, funeral expenses) and certify that (i) the information they have entered is accurate, and (ii) they will retain back-up documentation as proof of the financial need. Plan sponsors rely on this self-certification and do not collect or review any back-up documentation related to the hardship withdrawal. While some plan sponsors have received pushback from the IRS regarding this process during audits, the IRS has not issued formal guidance that this practice violates the hardship withdrawal requirements.
The IRS’s Warning
In its latest newsletter, the IRS reiterated that plan sponsors are ultimately responsible for plan administration and proper recordkeeping requirements. Sponsors should therefore retain all records related to hardship withdrawals, including financial information that substantiates and documents the employee’s immediate and heavy financial need, or risk jeopardizing the plan’s tax-qualified status. The IRS cautioned that it is not enough to require employees to retain these records, because employees may leave employment or fail to keep copies, thus making their records inaccessible in the event of an IRS audit. In its strongest statement yet on this issue, the IRS explicitly stated that electronic self-certification is not sufficient evidence of an employee’s immediate and heavy financial need.
Although this latest statement from the IRS comes in the form of an Employee Plans newsletter and not formal guidance, it highlights the fact that plan sponsors that use a self-certification process will continue to face pushback and potential penalties from the IRS during plan audits.