If your 401(k) plan recordkeeper has not talked to your company lately about hardship distributions, it may be time to reach out to the recordkeeper. The short story is that the IRS recently issued an internal memorandum (found here https://www.irs.gov/pub/foia/ig/spder/tege-04-0217-0008.pdf) providing guidance to its employee plans examination group on the substantiation requirements for hardship distributions from a section 401(k) plan. While this is not binding on the IRS as a statement of the law, it is useful in that it provides some indication of how the IRS would approach this issue in an audit.
By way of background, the law provides a list of expenses and costs for which a distribution would be considered on account of immediate and heavy financial need. Historically, plan administrators and recordkeepers have struggled to find a balance between ensuring compliance with the need requirement and making the process more efficient for plan participants. A number of recordkeepers allowed participants to “self-certify” electronically and required little substantiation of the expenses, but IRS officials informally questioned whether self-certification was sufficient—most recently in a 2015 post in Employee Plans News that said plan sponsors should retain documentation and that “electronic self-certification is not sufficient documentation of the nature of a participant’s hardship.”
The latest guidance maintains the position that self-certification alone is not enough, but offers an acceptable alternative to full substantiation.
Specifically, the guidance seems to provide two substantiation options.
First, the recordkeeper could require that a participant provide full underlying documentation (or what it calls source documents) substantiating the claim, such as estimates, contracts, bills and statements from third parties.
Second, the recordkeeper could require that the participant provide a summary of the information contained in the source documents. The summary could be in paper or electronic form or in telephone records. But if the summary is used, there are additional requirements:
- The summary information provided by the participant must include (i) the participant’s name; (ii) the total cost of the hardship event; (iii) the amount of distribution requested; and (iv) certification by the participant that the information provided is true and accurate.
- The summary from the participant must also include additional information that depends on the type of hardship. For example, for medical expense hardship, the information must include (i) the name of the person incurring the expense; (ii) the relationship to the participant; (iii) the general category of the purpose of the medical care (e.g., diagnosis, treatment, prevention, associated transportation, long-term care); (iv) name and address of the service provider; and (v) the amount of medical expenses not covered by insurance. Each type of hardship has its own enumerated list.
- The recordkeeper must notify the participant that (i) the hardship distribution is taxable and additional taxes could apply; (ii) the amount of the distribution cannot exceed the immediate and heavy financial need; and (iii) hardship distributions cannot be made from earnings on elective contributions or from qualified nonelective or qualified matching contribution accounts (if applicable). Of these requirements, only item (ii) is directly related to the form of substantiation.
- The participant must also agree to preserve source documents and to make them available at any time, upon request, to the employer or recordkeeper.
In addition to the substantiation requirements, the IRS expects the recordkeeper to provide to the employer reports or other access to data on hardship distribution at least annually.
The guidance further suggests that IRS auditors might be skeptical of hardship distributions when summary documentation is used. In particular, the IRS is concerned about cases where an employee has more than two hardship distributions in a plan year. Absent an adequate explanation (e.g., tuition on a quarterly calendar), the IRS might ask for source documents. Auditors might also ask for source documentation if the employee’s summary is incomplete or inconsistent on its face.
The IRS’s openness to substantiation in a summary form will be welcome news to many administrators and plan sponsors. But accepting summary substantiation will require careful review by the recordkeeper and, even with that review, administrators and sponsors will have to rely on participants to maintain records.
Recordkeepers have now had a few months to process this recent guidance and react. Thus, now is a good time for plan sponsors to contact their recordkeepers to review their processes for approving hardship distributions and decide how best to proceed. Plan sponsors should consider whether the efficiency from reduced documentation is worth the potential for headaches in an IRS audit.