The Internal Revenue Service (IRS) recently issued updated audit guidelines for its agents regarding the substantiation requirements for hardship withdrawals from 401(k) and 403(b) plans. This guidance is welcome news for plan sponsors who rely on third party administrators to process participants’ requests for hardship withdrawals, as it relaxes previous IRS guidance which (1) required plan sponsors to obtain and store copies of the actual source documents (e.g., medical bills, cancelled checks, etc.) that established a participant’s request for a hardship withdrawal and (2) did not permit participant self-certification of hardship withdrawal requests.

Under the new guidance, the IRS makes it clear that in addition to requesting and maintaining the actual source documents, a plan sponsor may establish proper substantiation was obtained for a participant’s hardship withdrawal by requesting a “summary” of the source documents from the participant and relying on a participant’s self-certification of the financial need. In order to rely on a summary of such documents, the guidance requires the plan administrator to meet the following requirements:

  1. Prior to any hardship distribution, the plan sponsor must issue a notice to the participant providing:
    1. the distribution is taxable (and could be subject to additional taxes);
    2. the amount of the distribution cannot exceed the immediate and heavy financial need;
    3. the distribution may not be made from the earnings on the participant’s account balance (or QMACs or QNECs); and
    4. the participant must agree to preserve the source documents and make them available upon request.
  2. The plan sponsor must require the participant to provide a self-certification statement that contains:
    1. the participant’s name;
    2. the total cost of the hardship event (e.g., the cost of the medical care, funeral expenses, etc.);
    3. the amount of the requested distribution;
    4. certification from the participant that the information is true and accurate; and
    5. specific information about the actual immediate and heavy financial need causing the request for the hardship withdrawal (see Attachment I to the Memorandum for the specific information required to be provided).
  3. If the plan sponsor delegates hardship distribution administration to a third-party administrator (TPA), the TPA is required to provide the plan sponsor a report describing the hardship distributions made during a plan year, which report must be made on at least an annual basis.
  4. If (1) the agent determines that the participant notification or the summary is insufficient on its face, or (2) if the participant has received more than two hardship distributions in a plan year and the plan sponsor does not provide an adequate explanation (such as additional medical expenses or quarterly tuition bills were incurred), then the agent is directed to request the actual source documents from the plan sponsor or TPA.

It is important to note that this guidance only applies to “safe harbor” hardship distributions, which generally are those made on account of uninsured medical expenses, purchase of a principal residence, payment of tuition for post-secondary education, payments to avoid eviction from or foreclosure on a participant’s primary residence, payments for burial and funeral expenses, and payment for expenses to repair casualty damages to a participant’s primary residence.

While the recent IRS guidance does not rise to the level of law or official guidance, it does provide plan sponsors with direction to establish best practices for the electronic processing of hardship withdrawals. Plan sponsors who desire to take advantage of these relaxed requirements should update their plan communications and coordinate with their TPAs to ensure that the TPA is complying with the requirements provided under the guidance.