In an internal memorandum to its examination agents dated February 23, 2017, the Internal Revenue Service (IRS) issued guidance regarding the types of documentation that agents should request in verifying hardship withdrawals from 401(k) plans. Despite past statements to the contrary, based on the memorandum it appears that the IRS would generally accept an electronic hardship withdrawal application process in which an employee “self-certifies” that he or she has a safe harbor immediate and heavy financial need and provides a summary of his or her financial hardship in lieu of backup documentation. The new guidance should be helpful to many plan sponsors who have established electronic hardship withdrawal application processes in recent years.
Background The Internal Revenue Code and Treasury Regulations provide that employees may take hardship withdrawals from 401(k) plans only upon a showing of immediate and heavy financial need that cannot be met from other sources. A safe harbor under the regulations provides several types of financial needs that will be considered immediate and heavy. Formal guidance is silent on the type of proof an employee must provide under the safe harbor and the type of documentation the plan sponsor must keep on file.
Several third-party administrators have developed an entirely electronic hardship withdrawal application process, through which employees enter summary information about a particular financial need (e.g., medical expenses, tuition, pending foreclosure, funeral expenses) and certify that: (1) the information they have entered is accurate; and (2) they will retain backup documentation as proof of their financial need. Under this process, plan sponsors typically rely on the self-certification and do not collect or review backup hardship documentation at the time of the withdrawal.
Eversheds Sutherland Observation: Many plan sponsors who have used this type of all-electronic hardship application process have faced pushback from the IRS during audits. A 2015 IRS Employee Plans Newsletter even warned plan sponsors that they must obtain and keep the physical documentation necessary to substantiate an employee’s immediate and heavy need for a hardship withdrawal. The IRS cautioned that an electronic application process could be insufficient, because employees may leave employment or fail to keep copies, thus making their records inaccessible in the event of an IRS audit. This new guidance suggests a more flexible approach to the all-electronic hardship withdrawal process.
The Latest Guidance In the latest guidance on this issue, the IRS appears to have modified its prior position. The new memorandum advises agents that, subject to certain requirements, either (1) actual backup documentation or (2) an employee-provided summary of the backup documentation may serve as sufficient proof of an employee’s immediate and heavy financial need under the safe harbor provisions of the hardship regulations. Based on the memorandum, it appears that the entirely electronic hardship withdrawal application process offered by many third-party administrators is generally an acceptable way to approve hardship withdrawals, subject to the following additional conditions:
- Employees must receive certain notifications, including a statement that the employee agrees to preserve any backup documentation and make it available at any time upon request by the employer or the third-party administrator;
- The third-party administrator should provide a report or other data to the employer, at least annually, that describes hardship withdrawals made during the plan year;
- If summary information provided by employees is incomplete or inconsistent on its face, the examining agent may request backup documents to substantiate the hardship from the employer or third-party administrator; and
- If an employee receives more than two hardship withdrawals in one plan year, the IRS noted that an agent may, with managerial approval and in the absence of an adequate explanation, request additional physical backup documentation to verify the hardships.
Eversheds Sutherland Observation: As a result of these audit guidelines, plan sponsors and administrators using an all-electronic hardship application process that allows more than two hardship withdrawals in a plan year may wish to establish a new rule requiring an employee to provide the physical backup documentation for all hardship distributions received during the plan year at the time the employee requests a third hardship withdrawal in the same plan year, rather than needing to locate this documentation in the event of an IRS audit. Alternatively, plan sponsors may wish to amend their plans to limit employees to two hardship withdrawals per plan year.
Eversheds Sutherland Observation: The IRS memorandum includes an attachment that lists the information that the IRS believes an employee should provide in documenting a safe harbor hardship. Plan sponsors and administrators should consider using this as a checklist when reviewing the information they require in connection with hardship withdrawals.
Although this latest guidance from the IRS comes in the form of an internal memorandum upon which taxpayers cannot rely, it suggests that plan sponsors may no longer face pushback and potential penalties during plan audits merely because they have implemented an electronic hardship withdrawal application process.