On September 23, 2019, the Internal Revenue Service (IRS) and the U.S. Department of the Treasury (Treasury) published final regulations that amend rules relating to hardship distributions from 401(k) and certain other plans.1 The regulations are effective immediately and reflect statutory changes to the Internal Revenue Code (Code), including changes made by the Bipartisan Budget Act of 2018 (BBA 2018).
The final regulations are substantially similar to the proposed regulations issued by the IRS and Treasury on November 14, 2018, and plans that complied with the proposed regulations will satisfy the final regulations.
The following provides context that may be helpful in understanding the key changes to the hardship rules described below.
An employee’s elective contributions to a 401(k) plan can be distributed only upon the occurrence of certain events, one of which is the employee’s hardship. If a plan permits hardship distributions, such distributions must (i) be made on account of an immediate and heavy financial need and (ii) be necessary to satisfy such need (plus any amounts necessary to pay any taxes or penalties reasonably anticipated to result from the distribution).
Under prior regulations, whether a distribution satisfied the requirements to be considered a hardship distribution was determined on the basis of all the relevant facts and circumstances and in accordance with nondiscriminatory and objective standards set forth in the plan.
There were safe harbors available under prior regulations to simplify administration and facilitate compliance with hardship rules. These included (i) a safe harbor list of expenses deemed to trigger an immediate and heavy financial need and (ii) a safe harbor by which a distribution was deemed necessary to satisfy an immediate and heavy financial need if an employee had obtained all currently available distributions (including distributions of employee stock ownership plan (ESOP) dividends under section 404(k) of the Code) and nontaxable loans from the plan and any other plans maintained by the employer, and the employee’s ability to make elective contributions and employee contributions to such plans was suspended for at least six months after the receipt of the hardship distribution.
Earnings on elective deferrals, qualified nonelective contributions (QNECs) and qualified matching contributions (QMACs) were generally not permitted to be distributed on account of hardship (subject to certain exceptions with respect to grandfathered amounts).
Key Changes to Hardship Distribution Rules
Immediate and Heavy Financial Need – Modifications to Safe Harbor List of Expenses
1. Nonapplicability of TCJA Limitation to Personal Casualty Loss Deduction. One of the safe harbor expenses listed in the regulations (under both the prior regulations and the final regulations) is expenses for the repair of damage to the employee’s principal residence that would qualify for the casualty deduction under section 165 of the Code. The final regulations provide that the limitation imposed on this deduction under the Tax Cuts and Jobs Act of 2017 (TCJA) — that the deduction for personal casualty loss generally is available for taxable years 2018 through 2025 only to the extent the loss is attributable to a federally declared disaster — does not apply in the context of hardship distributions. This effectively restores the pre-TCJA treatment of this expense.
2. Disaster-Related Hardship Distribution. The final regulations add a new safe harbor expense to the list, relating to expenses (including loss of income) incurred as a result of a federally declared disaster that occurs in the area of the employee’s principal residence or principal place of employment (this is narrower than prior IRS Announcements providing similar disaster relief, which also permitted a hardship distribution on account of losses incurred by the employee’s relatives and dependents). Plan sponsors who determine to offer disaster-related hardship distributions must add such distributions to the list of permissible expenses by the end of the plan year in which they permit such distributions to be made.
Distribution Necessary to Satisfy Financial Need – Modifications to Rules
3. Elimination of Safe Harbor. The safe harbor provisions for determining whether a distribution is necessary to satisfy an immediate and heavy financial need were eliminated:
a. No Requirement to Take Plan Loans. The final regulations do not require 401(k) plans to provide that an employee must take all available nontaxable plan loans prior to obtaining a hardship distribution. However, a plan sponsor may elect to maintain this plan provision (e.g., if the plan sponsor is attempting to minimize plan leakage).
b. No Six-Month Suspension Permitted for 401(k) Plans. Effective January 1, 2020, 401(k) plans may not suspend an employee’s ability to make elective contributions and employee contributions after the receipt of a hardship distribution. Plan sponsors do not have discretion to require a suspension. (This rule does not, however, apply to certain other plans including nonqualified deferred compensation plans subject to section 409A of the Code (409A). Plan sponsors of nonqualified deferred compensation plans subject to 409A may wish to evaluate the continued maintenance of any plan provision that automatically cancels a deferral election thereunder upon the participant’s hardship distribution under a 401(k) plan.)
4. Adoption of General Standard. The final regulations provide one general standard for determining whether a distribution is necessary to satisfy an immediate and heavy financial need:
a. Distribution May Not Exceed Need. A hardship distribution may not exceed the amount of an employee’s need (including any amounts necessary to pay any federal, state or local income taxes or penalties reasonably anticipated to result from the distribution).
b. No Alternative Means Reasonably Available. The employee must have obtained all other currently available distributions (including distributions of ESOP dividends under section 404(k) of the Code) under the plan and all other plans of deferred compensation, whether qualified or nonqualified, maintained by the employer.
c. Employee Representation Required. The employee must provide a representation that he or she has insufficient cash or other liquid assets “reasonably available” to satisfy the need. Such representation may be provided in writing (including by email) or by recorded verbal representation via telephone. “Reasonably available” funds do not include liquid assets earmarked for payment of an obligation in the near future.
d. Administrator Must Not Have Contrary Knowledge. The plan administrator must not have actual knowledge that is contrary to the employee’s representation (there is no obligation on the plan administrator to conduct an inquiry into the employee’s financial condition).
5. Additional Conditions Permitted. The final regulations provide that plans generally may include additional conditions to demonstrate that a distribution is necessary to satisfy an employee’s financial need (e.g., completion of the plan’s application process or provision of required documentation).
Expanded Sources for Hardship Distributions
6. A plan may permit (but is not required to permit) hardship distributions from 401(k) plans of elective contributions, QNECs, QMACs and earnings on these amounts, regardless of when contributed or earned.
Applicability Dates; Amendment Deadlines
Generally, the final hardship regulations are effective for hardship withdrawals made on or after January 1, 2020, but a plan sponsor may choose to apply the changes on or after January 1, 2018. If a plan sponsor chooses to apply the new rules to distributions made prior to January 1, 2020, it may do so without regard to the new employee representation requirement and the prohibition on suspensions.
Plan sponsors of individually designed, nongovernmental plans will be required to amend their plans to reflect the new hardship guidance by the end of the second calendar year that begins after the new hardship rules are included in a Required Amendments List published by the IRS. Assuming that the 2019 Required Amendments List includes the new hardship rules, the deadline for amendments will be December 31, 2021.