Earlier this month, the IRS proposed changes to existing rules governing distributions from 401(k) and 403(b) plans on account of certain financial hardships. The proposed regulations reflect several statutory changes enacted by the 2017 Tax Act, the Bipartisan Budget Act of 2018 and the Pension Protection Act of 2006.
If finalized as proposed, plan sponsors will need to amend their plans’ hardship distribution provisions for applicable changes and modify plan administrative procedures to reflect the new rules. Certain changes may be effective for the 2018 plan year, while others will not take effect until the plan year beginning on or after Jan. 1, 2020.
Generally, 401(k) and 403(b) plans may permit distribution of elective deferrals on account of certain financial hardships if two requirements are satisfied: (1) the distribution is made in response to an “immediate and heavy financial need” and (2) the distribution is necessary to satisfy that financial need. Hardship distributions offered under a 401(k) or 403(b) plan can satisfy these requirements by meeting either a safe-harbor or a non-safe-harbor standard set forth in the Treasury regulations.
Non-Safe-Harbor Hardship Distributions
Under the existing non-safe-harbor standard, a facts-and-circumstances analysis is used to determine whether a distribution is made on account of a financial need. For example, the need to pay funeral expenses would qualify as a financial need, whereas purchasing a boat generally would not. Plan administrators generally are permitted to allow a participant to self-certify that the distribution is necessary to satisfy the financial need.
Safe-Harbor Hardship Distributions
Under the existing safe-harbor standard, a qualifying financial need may be one or more of the following:
- expenses for medical care deductible under Code Sec. 213(d) for the plan participant or the participant’s spouse, children or dependents;
- costs directly related to the purchase of a primary residence;
- payment of tuition, related educational fees, room and board expenses for up to the next 12 months of post-secondary education for the plan participant or his or her spouse, children or dependents;
- payments necessary to prevent the eviction of the plan participant from his or her primary residence or foreclosure of the mortgage on that residence;
- payments for burial or funeral expenses for the plan participant’s deceased parents, spouse, children or dependents; or
- expenses for the repair of damages to the plan participant’s principal residence that would qualify for the casualty deduction under Code Sec. 165.
A distribution is deemed necessary to satisfy the financial need if: (1) the participant has obtained all other currently available distributions and nontaxable loans under the plan and all other plans maintained by the employer, and (2) the participant is prohibited from making elective deferrals and other employee contributions to the plan and all other plans maintained by the employer for at least six months after receipt of the distribution.
Recent legislation made a number of changes affecting the existing hardship distribution rules. First, the 2017 Tax Act limited the casualty deduction under Code Sec. 165 to damages resulting from a federally declared disaster. Because the existing safe-harbor hardship standard refers directly to Code Sec. 165, this change would have prevented participants under plans using the safe-harbor standard from obtaining hardship distributions to pay for damages to their homes resulting from a storm, flood or other natural disaster, other than a federally declared disaster.
Second, the Bipartisan Budget Act of 2018 directed the IRS to modify the hardship regulations to eliminate the requirement that elective deferrals be suspended for six months following receipt of a hardship distribution. It also modified Code Sec. 401(k) by adding to the list of available sources of funds for hardship distributions and providing that a distribution will not fail to qualify as being on account of hardship solely because the employee does not take available loans from the plan.
Finally, the Pension Protection Act 2006 directed the IRS to modify the hardship regulations to treat a participant’s beneficiary the same as a spouse or dependents for purposes of the safe-harbor standard.
The proposal would modify the hardship withdrawal rules in several ways:
- Expanded Sources of Hardship Distributions. Currently, hardship distributions generally are permitted only from an employee’s elective deferrals under the plan. The proposed rules would amend the regulations to permit hardship distributions from elective deferrals, qualified non-elective contributions (QNECs) and qualified matching contributions (QMACs) (including safe-harbor contributions), and earnings on these amounts, regardless of when such amounts were contributed or earned.
- Deemed Immediate and Heavy Financial Need. The list of expenses for which a distribution is deemed on account of a financial need under the safe-harbor standard would be modified in three ways. First, the list would include qualifying medical, educational and funeral expenses for a participant’s “primary beneficiary under the plan.” Second, the new federally declared disaster limitation for casualty deductions under Code Sec. 165, as added by the 2017 Tax Act, would not apply for purposes of the safe harbor. Third, a new category would be created for expenses and losses (including loss of income) incurred on account of certain federally declared disasters. This last change avoids the delay and uncertainty in accessing plan funds after a natural disaster; in the past, plans and participants generally relied on the IRS to provide specific guidance on plan distributions following a disaster, as they did after Hurricane Katrina in 2005 and the California wildfires in 2017.
- Elimination of Suspension Requirement. Beginning Jan. 1, 2020, plans would be prohibited from suspending an employee’s contributions following the receipt of a hardship withdrawal. Plan sponsors may choose to eliminate suspension requirements earlier than the 2020 plan year, however. See the effective date discussion below.
- Elimination of Plan Loan Requirement. Participants would no longer be required under the safe-harbor standard to first take a plan loan before receipt of a hardship distribution. Unlike the removal of the suspension requirement for the 2020 plan year, plans may, as an optional plan design feature, continue to require receipt of plan loans (as well as provide for certain additional conditions) before hardship distributions.
- Distributions Necessary to Satisfy Financial Need. To ease administration, the rules under the non-safe-harbor standard would be amended to provide one general standard for determining whether a distribution is necessary to satisfy a financial need. Under this standard: (1) a hardship distribution may not exceed the amount of the need, including amounts for taxes and penalties; (2) the employee must have obtained other available distributions under the employer’s plans; and (3) beginning Jan. 1, 2020, the employee must represent that he or she has insufficient cash or other liquid assets to satisfy the financial need.
- Section 403(b) Plans. Because the Treasury regulations under Code Sec. 403(b) incorporate the Code Sec. 401(k) regulations by reference for hardship distributions from Code Sec. 403(b) plans, the changes described in the proposed regulations largely also apply to Code Sec. 403(b) plans, with a few exceptions. For example, income attributable to Code Sec. 403(b) elective deferrals continues to be ineligible for hardship distribution, and QNECs and OMACs in a Code Sec. 403(b) plan that are in a custodial account also continue to be ineligible for hardship distribution.
The proposed rules generally would apply to distributions made after Dec. 31, 2018, but plan sponsors have several options for earlier application:
- Elective deferral suspensions following receipt of a hardship distribution may be eliminated as of the first day of the first plan year beginning after Dec. 31, 2018, even if the distribution was made in the prior plan year. Thus, a calendar-year plan may be amended to provide that an employee who receives a hardship distribution in the second half of 2018 will be prohibited from making contributions only until Jan. 1, 2019 (or the plan may continue to provide that contributions will be suspended for the originally scheduled six months).
- The revised list of expenses under the safe-harbor standard may be applied to distributions made as early as Jan. 1, 2018. Thus, plans may be amended to allow hardship distributions during 2018 for qualifying casualty losses, without regard to whether the loss was due to a federally declared disaster. Similarly, a plan may apply the new federal disaster expense category for disasters occurring during 2018.
The IRS is accepting comments on the proposal through Jan. 14, 2019.
Next Steps for Plan Sponsors
Many of the changes from the 2017 Tax Act and the Bipartisan Budget Act of 2018 carry effective dates that potentially involve distributions in the 2018 and 2019 plan years. Therefore, before the end of the year, plan sponsors are encouraged to take some preliminary steps:
- Review hardship distribution provisions in Code Sec. 401(k) and 403(b) plan documents.
- Determine which of the modifications described in the proposed regulation apply to the plan, and when or whether to implement any changes, including the adoption of related plan amendments.
- Review and discuss any operational changes (such as plan account sourcing or participant hardship self-certification forms) with third-party administrators.