The Internal Revenue Service (IRS) recently updated the Examination Steps for General Hardship in the Internal Revenue Manual (IRM) to incorporate the summary substantiation method for safe-harbor hardship distributions. Plan sponsors should consider whether they want to adopt this method of substantiating hardship withdrawals, rather than requiring participants to provide documentation supporting the existence of an “immediate and heavy financial need.”
The IRS issued internal guidance in February 2017 to its employees conducting plan audits, setting forth guidelines for what 401(k) plan sponsors and administrators are required to show as substantiation to support that a hardship withdrawal was due to an immediate and heavy financial need under the safe-harbor standards for a hardship distribution under Treas. Reg. Section 1.401(k)-1(d)(3)(iii)(B).
If the plan uses the deemed hardship distribution standards, the memo instructed examiners to determine whether the sponsor or plan administrator obtains source documents prior to making a hardship distribution, such as bills and statements from third parties, or a summary of the information included in the source documents. The reference to obtaining a summary suggested that employers and administrators might not be required to obtain the underlying documentation from participants, but simply a summary of the documents in their possession, which appeared to be a change in the IRS’s official position on this issue. However, the memo was for internal IRS use only, and until the current IRM update, there was no official recognition of the change. The advantage of the summary method is that the participant receiving the hardship distribution, rather than the plan administrator, must maintain the records to substantiate the hardship distribution, which eases the administrator’s recordkeeping burden (particularly where applications for withdrawals are handled electronically).
By updating the IRM, the IRS has now officially made it clear that employers have a choice on whether to seek source documents from a participant prior to making a hardship distribution, such as bills and statements from third parties, or whether they simply obtain a summary of the information included in the source documents. Hardship documentation is preserved by the employee as opposed to the employer or plan administrator in the case of the summary substantiation method.
The IRM states that if the employer/third party uses a summary of information in source documents, an IRS auditor examining hardship withdrawals needs to determine whether the employer or third party provides the employee certain required notifications before making a hardship distribution. The IRM (in an exhibit) states that to utilize the summary substantiation method, the plan sponsor must notify the participant seeking a hardship distribution of each of the following:
- The hardship distribution is taxable and additional taxes could apply
- The amount of the distribution cannot exceed the immediate and heavy financial need
- Hardship distributions cannot be made from earnings on elective contributions or from QNEC or QMAC accounts, if applicable
- The recipient agrees to preserve source documents and to make them available at any time, upon request, to the employer or administrator
The plan sponsor must also obtain information from the participant based on the type of safe-harbor hardship distribution the participant requests. That information is also itemized in the IRM Exhibit (4.72.2-2).
Plan Sponsor Action
The changes that the IRS made to the IRM signal how IRS auditors will review documentation of deemed hardships, and plan sponsors can look to the IRM as official recognition of the hardship summary substantiation method that was previously only referenced in an internal EP Examinations memo. Plan administrators can change plan operations to take advantage of this method, and plan sponsors can amend their plans accordingly. However, even if a plan sponsor elects to use the summary substantiation method, the IRS retains the right to ask for and review hardship source documents. If a participant hasn’t retained the documentation or cannot be located, the plan sponsor is ultimately responsible for compliance with the hardship distribution rules. In the case of plan audit, the employer might not be able to produce documentation to support a hardship distribution if using the summary substantial method, and runs the risk of disqualification. The convenience afforded by the summary substantiation method may not outweigh the employer’s risk of non-compliance that could be avoided if the employer or plan administrator continued to request hardship documentation from the employee and retained that documentation indefinitely. Therefore, an employer needs to balance this increased audit risk against the convenience of using the summary substantiation method.