The IRS has now issued final regulations under Code Section 401(k) modifying and clarifying the rules for in-service distribution of elective deferrals (and other amounts subject to statutory withdrawal restrictions) from 401(k) plans and 403(b) plans on account of financial hardship. The final regulations are substantially similar to the proposed regulations issued in November of 2018 (as described in our previous Client Alert). Fortunately, plans that complied with the proposed regulations will be deemed to satisfy the final regulations.
As noted in the Client Alert, the proposed regulations (and now the final regulations) reflect several statutory changes to 401(k) plans since the Pension Protection Act of 2006, including certain provisions of the Tax Cuts and Jobs Act of 2017 (sometimes referred to as “Trump Tax Reform”) and the Bipartisan Budget Act of 2018. Those changes fall into three general categories: (i) expanding the types of contributions (and earnings) that may be distributed on account of financial hardship; (ii) modifying (and expanding) the “safe-harbor” list of expenses that are deemed to constitute an “immediate and heavy financial need”; and (iii) creating a single, new standard for determining whether a distribution is “necessary” to satisfy the participant’s financial need.
The Proposed Regulations
The proposed regulations (which were published on November 9, 2018) answered several questions about the changes made to the hardship rules by the Trump Tax Reform and Bipartisan Budget Act legislation, and provided transition relief for hardship distributions made in 2019. Some of the highlights of the proposed regulations included:
- Clarifying that hardship distributions made in plan years beginning on or after January 1, 2019 may – but are not required to – include post-1988 earnings on elective deferrals under 401(k) plans (but not 403(b) plans), as well as QNECs, QMACs and “safe-harbor” employer contributions (and the earnings thereon) under 401(k) plans and 403(b)(1) annuity contracts (but not under 403(b)(7) custodial accounts);
- Clarifying that, for distributions on or after January 1, 2018, damage to a participant’s primary residence due to a casualty loss that would otherwise be deductible under Code Section 165 (without regard to the percentage of AGI limitation) does not have to have occurred in a federally-declared disaster area to qualify as a “safe-harbor” expense that is deemed to be an “immediate and heavy financial need”;
- Formalizing prior guidance indicating that a participant’s “primary beneficiary under the Plan” (in addition to the participant’s spouse or Tax Code dependent) may be treated as an individual who has incurred qualifying medical, educational and funeral expenses (which are also “safe-harbor” categories of immediate and heavy financial need);
- Adding a new (seventh) “safe-harbor” category of immediate and heavy financial need for expenses or losses incurred as a result of certain disasters if the participant’s principal residence or principal place of employment at the time of the disaster was located in an area designated by FEMA for individual assistance;
- Replacing both the “safe harbor” and the “facts and circumstances” alternatives with a single new standard that must be satisfied in order to show that a distribution is “necessary” to satisfy the participant’s financial need. Under that new standard (which is required for hardship distributions on or after January 1, 2020, but optional for distributions made in the 2019 plan year but prior to that date):
- The distribution may not exceed the amount of the participant’s need (including the anticipated taxes and penalties that the participant may incur as a result of the distribution);
- The participant must have obtained all other available distributions (other than hardship distributions) under the employer’s retirement plans;
- The participant must represent, in writing, that he/she has insufficient cash or liquid assets to satisfy the financial need; and
- The plan administrator may rely on the participant’s written representation (regarding insufficient assets) unless the administrator has actual knowledge to the contrary;
- Indicating that, even though plans may impose additional restrictions on a participant’s ability to obtain a hardship distribution, they may not require suspension of elective deferrals (such as the six-month suspension period that was previously mandated under the “safe-harbor” alternative for the “amount necessary” requirement) for distributions made on or after January 1, 2020;
- Clarifying that, even though there is no longer a requirement that a participant first obtain all available participant loans before taking a hardship distribution, plans may, if they choose, continue to impose such a prerequisite; and
- Clarifying that plans may discontinue the practice of suspending deferrals for six months following a hardship distribution effective as early as the first day of the 2019 plan year, even with respect to hardship distributions that were taken in the last half of the previous (2018) plan year.
The final regulations are substantially similar to the proposed regulations, but with the following changes or clarifications:
- With respect to the new “safe-harbor” for disaster-related expenses and losses, the final regulations clarify that only the expenses of the employee who lived or worked in the disaster area (not the expenses of a relative or dependent) will qualify. There is no specific deadline by which a request for a disaster-related hardship distribution must be made.
- With respect to the requirement that an employee represent, in writing or via an electronic medium, that he or she has insufficient cash or liquid assets to satisfy the financial need, the final regulations note that the representation only relates to whether the employee has cash or liquid assets that are “reasonably available” to satisfy the need (as opposed to having any cash or liquid assets), and that a verbal representation via a recorded telephone call is an acceptable method of making the representation.
- With respect to the requirement that the plan administrator have no “actual knowledge” that is contrary to the employee’s representation, the final regulations clarify that the plan administrator need not inquire into the financial condition of an employee who requests a hardship distribution, as the rule is limited to situations where the plan administrator already possesses information that is contrary to the employee’s representation.
- The regulations clarify that plans may continue to impose additional conditions (other than suspension of deferrals) on an employee who requests a hardship distribution, including the requirement to complete an application process and/or to provide certain documentation in support of the request.
- The regulations also clarify that the prohibition on suspension of deferrals as a condition of obtaining a hardship distribution applies only to qualified plans, 403(b) plans, and Section 457(b) eligible deferred compensation plans maintained by an eligible (governmental or tax-exempt) employer, meaning that a plan sponsor may continue to require suspension of elective contributions to a nonqualified plan subject to Code Section 409A.
- The final regulations generally apply to distributions made on or after January 1, 2020, whereas the proposed regulations generally applied to distributions made in plan years beginning after December 31, 2018. Plan sponsors may, however, choose to apply the final regulations to distributions made in plan years beginning after December 31, 2018, and (as permitted in the proposed regulations) the prohibition on suspension of elective deferrals may be applied as of the first day of the 2019 plan year, even if the distribution was made in the prior year.
- The revised list of safe-harbor expenses may be applied to distributions made on or after a date that is as early as January 1, 2018. Consequently, a plan may be amended to apply the new category of safe-harbor expense (for disaster-related expenses and losses) to disasters that occurred in 2018, provided the employee’s principal residence or principal place of employment at the time of the disaster was located in a FEMA-declared disaster area.
The preamble to the final regulations indicates that plans will generally need to be amended to reflect the final hardship regulations, and that such amendments must be effective for distributions beginning no later than January 1, 2020. The deadline for amending a “disqualifying” provision in an individually designed plan (other than a governmental plan) is the end of the second calendar year that begins after the IRS issues a Required Amendments List (RAL) that includes the change. This is also the deadline for plan provisions that are “integrally related” to a qualification requirement that has changed in a manner that requires a plan amendment. Therefore, if the final hardship regulations are included in the 2019 RAL, the deadline to amend individually designed plans for disqualifying provisions and integrally related provisions will be December 31, 2021. If the regulations are not included until the 2020 RAL, the deadline will be the last day of 2022.
The preamble provides that the following changes are considered to be “integrally related” to a qualification requirement that has been changed by the final regulations:
- The change to section 165 (regarding casualty losses);
- The addition of the new safe-harbor expense for disaster-related expenses or losses; and
- The extension of the relief under Announcement 2017-15 to victims of Hurricanes Florence and Michael that was provided in the preamble to the proposed regulations.
Amendments that are purely discretionary(i.e., changes to plan terms that are not disqualifying or “integrally-related” provisions) must be adopted by the last day of the plan year in which they are first effective. Therefore, if a plan sponsor elects to impose (in operation) an additional condition that must be satisfied before a participant can obtain a hardship distribution, and this condition is not required under the final regulations, the plan must be amended to reflect such condition by the last day of the plan year in which the condition is first effective. There are also separate rules for the timing of amendments to pre-approved plans.