The Internal Revenue Service (the “IRS”) issued final regulations, effective September 23, 2019 (the “Final Regulations”), that modify the hardship distribution rules for plans established under Section 401(k) of the Internal Revenue Code of 1986, as amended (the "Code"). The Final Regulations are substantially similar to the proposed regulations issued by the IRS in November 2018 (the “Proposed Regulations”), which updated the prior regulations under Section 401(k) of the Code to reflect changes made by the Bipartisan Budget Act of 2018 (the “BBA”), the Tax Cuts and Jobs Act, the Pension Protection Act of 2006 (the “PPA”) and the Heroes Earnings Assistance and Relief Tax Act of 2008. Below is a brief summary of those updates as set forth in the Final Regulations.
The Final Regulations generally provide that contributions made pursuant to a cash or deferred arrangement may be distributed only upon the occurrence of certain events, one of which is an employee’s hardship.1 For a distribution to be treated as having been made on account of an employee’s hardship, the distribution must be made on account of an employee’s immediate and heavy financial need and must be necessary to satisfy the financial need.
Immediate and Heavy Financial Need
In the safe harbor list of expenses for which a distribution would be deemed to be on account of an employee’s immediate and heavy financial need, the Final Regulations expand the group of individuals for whom qualifying medical, education and funeral expenses may be incurred to include a “primary beneficiary under the plan,” which reflects changes made by the PPA.2 The Final Regulations also clarify that for purposes of the expenses relating to damage to an employee’s principal residence, the limitations set forth in Section 165(h)(5) of the Code do not apply.3 Additionally, for purposes of expenses related to medical care, the outdated reference to whether expenses exceed 7.5% of adjusted gross income has been replaced with a reference to the limitations in Section 213(a) of the Code relating to the applicable percentage of adjusted gross income (10%) and the recipients of medical care.
The Final Regulations also expand the safe harbor list of expenses by incorporating expenses and losses incurred by an employee on account of a disaster declared by the Federal Emergency Management Agency. In the preamble to the Final Regulations, the IRS clarifies that this new safe harbor expense is “intended to eliminate any delay or uncertainty concerning access to plan funds that might otherwise occur following a major disaster.” As a result of the new safe harbor expense, the IRS expects that future disaster relief announcements will no longer be needed.
Necessary to Satisfy Immediate and Heavy Financial Need
To be considered necessary to meet a financial need, the amount of the hardship distribution may not be more than what is necessary to satisfy the employee’s financial need, including amounts necessary to pay applicable taxes and penalties. The Final Regulations removed the safe harbor under which a distribution was deemed necessary to satisfy an immediate and heavy financial need if (1) the employee had obtained all other currently available distributions and nontaxable loans under the applicable plan and all other plans of the employer and (2) under the terms of the plan or a legally enforceable agreement, the employee was prohibited from making elective contributions and employee contributions to the plan and all other plans maintained by the employer for at least six months after receiving a hardship distribution. Instead, the Final Regulations provide one general standard for determining whether a hardship distribution is necessary. First, an employee must exhaust all other currently available distributions (other than hardship distributions or loans) under all qualified and nonqualified plans maintained within the employer’s controlled group. Second, an employee must provide a representation to the plan administrator in writing or by electronic medium that the employee’s financial hardship could not reasonably be relieved by cash or other liquid assets reasonably available to satisfy the need. This representation may be relied upon unless a plan administrator has actual knowledge to the contrary. The Final Regulations clarify that plan administrators do not have an obligation to inquire as to the financial condition of employees seeking hardship distributions. “Rather, the rule is limited to situations in which the plan administrator already possesses sufficiently accurate information to determine the veracity of an employee representation.”
The Final Regulations allow plans to impose additional conditions to obtain hardship distributions, including conditions previously required under the prior regulations, such as requiring an employee to exhaust all nontaxable loans available under the plan and all other plans maintained by the employer. However, the Final Regulations prohibit a plan from providing for a suspension of an employee’s elective contributions or employee contributions to a tax-qualified plan as a condition for obtaining a hardship distribution. In the preamble to the Final Regulations, the IRS recognized “Congress’ expressed concern that a suspension impedes an employee’s ability to replace distributed funds.”
Sources for Hardship Distributions
The Final Regulations reflect statutory changes to Code Section 401(k) made by the BBA regarding the sources from which hardship distributions may be taken. Previously, hardship distribution sources were restricted to an employee’s total balance of elective contributions as of the date of distribution. The prior regulations specifically provided that hardship distributions generally could not derive from qualified non-elective employer contributions (“QNECs”), qualified matching contributions (“QMACs”) or post-1988 earnings on elective contributions, QNECs or QMACs. However, the BBA added Section 401(k)(14) to the Code, which permits QNECs, QMACs and post-1988 earnings on elective contributions, QNECs and QMACs to be available for hardship distributions. The Final Regulations are now updated to reflect that prior statutory change. It is important to note that safe harbor contributions are, by definition, QNECs and QMACs and are therefore also available for hardship distributions. The preamble to the Final Regulations clarifies that a plan may nonetheless limit the types of contributions that are available for hardship distributions and may exclude earnings on those contributions.
Prohibition on Suspension of Plan Contributions
In a deviation from the Proposed Regulations, the Final Regulations provide that the prohibition on suspensions of elective contributions and employee contributions is limited to qualified plans under Section 401(a) of the Code, plans under Section 403(b) of the Code and governmental plans under Section 457(b) of the Code. The preamble to the Final Regulations clarifies that an unfunded nonqualified plan subject to Section 409A of the Code may retain its suspension requirement (or, to the extent consistent with Section 409A of the Code, the plan may be amended to remove it).
Sufficiency of Other Assets
With respect to the required employee representation that the employee has insufficient cash or other liquid assets available to satisfy the financial need, the Final Regulations now clarify that the employee representation only relates to whether the employee has cash or other liquid assets that are “reasonably available.” In the preamble to the Final Regulations, the IRS indicated that “an employee could make a representation that he or she has insufficient cash or other liquid assets reasonably available to satisfy a financial need even if the employee did have cash or other liquid assets on hand, provided those assets were earmarked for payment of an obligation in the near future (for example, rent).”
As plan administrators may recall, the Proposed Regulations modified the existing Section 401(k) regulations to provide that an employee representation regarding the unavailability of cash or other liquid assets could be made by an “electronic medium.” In the preamble to the Final Regulations, the IRS indicates that a verbal representation by telephone, if recorded, is a representation by an “electronic medium.”
Generally, the Final Regulations apply to distributions made on or after January 1, 2020. However, the Final Regulations allow plan sponsors to apply the new rules to distributions made in plan years beginning after December 31, 2018.
Possible Next Steps
Plan sponsors should ensure that they are operationally in compliance with the Final Regulations by January 1, 2020. Code Section 401(k) plan amendments must be adopted by December 31, 2021. Plans administrators that have started to modify their operations and documents because of changes in the law or the Proposed Regulations will want to carefully review any changes to their operations or recently adopted amendments to confirm they are still in compliance with the Final Regulations. This would also be an appropriate time for administrators to review any forms related to hardships (e.g., election forms, webpages, or safe harbor plan notices) as well as summary plan descriptions and employee handbooks to make sure the documents are up to date.