On February 23, 2017, the Internal Revenue Service (“IRS”) issued a memorandum outlining substantiation guidelines for IRS employees to use when examining section 401(k) plan hardship distributions and determining whether the hardship distributions were made on account of an immediate and heavy financial need. This IRS memorandum helps employers and plan administrators understand what IRS agents will be looking for when auditing a 401(k) plan’s hardship distributions.
Rules: A hardship distribution is defined as a distribution made on account of an immediate and heavy financial need of the employee and which is necessary to satisfy the financial need. §1.401(k)-1(d)(3)(i) of the Income Tax Regulations. Distributions made under the following circumstances are deemed to be on account of an immediate and heavy financial need under §1.401(k)-1(d)(3)(iii)(B) of the Income Tax Regulations:
- Expenses for medical care deductible under section 213(d) for the employee or the employee’s spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan;
- Costs directly related to the purchase of a principal residence;
- Payment of tuition, related educational fees, room and board expenses for up to the next 12 months of post-secondary education for the employee or the employee’s spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan;
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence;
- Payments for burial or funeral expenses for the employee’s deceased parents, spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan; or
- Expenses for the repair of damages to the employee’s principal residence that would qualify for the casualty deduction under section 165.
During an examination of hardship distributions made by a 401(k) plan, the IRS memorandum clarifies that the IRS agent will want to see substantiation documents to determine whether a hardship distribution was made on account of one of the above situations and is therefore on account of an immediate and heavy financial need. It is imperative that employers and third party administrators gather evidence, such as source documents or summaries of source documents, in order to substantiate the employee/participant’s financial need for the distribution. Source documents include estimates, contracts, bills and statements from third parties which show the specifics (cost, vendor, dates, etc.) for the expenses that necessitate the distribution. The IRS agent, during its examination, will look to make sure the substantiation documents (source documents or summaries of source documents) match the amounts actually distributed. If the amounts match and the employer or third party administrator is able to provide documents that prove the reasons or expenses that necessitated the distribution (funeral expenses, tuition payments, repair of home expenses, etc.), the plan will be treated as satisfying the substantiation requirements for making hardship distributions deemed to be on account of an immediate and heavy financial need.
It is important to note, that if a summary of information on source documents is used, the IRS agent will need to determine whether the employer or third party administrator provided the employee with the notifications required on Attachment 1 of the memorandum prior to making the hardship distribution. Attachment 1 outlines the following information that must be provided to the employee:
- The hardship distribution is taxable and additional taxes could apply;
- The amount of the distribution cannot exceed the immediate and heavy financial need;
- Hardship distributions cannot be made from earnings on elective contributions or from QNEC or QMAC accounts, if applicable; and
- The recipient agrees to preserve source documents and to make them available any time, upon request, to the employer or administrator.
If the third party administrator obtains a summary of information contained in source documents, it is best practice to have the third party administrator provide a report or other access to data to the employer, at least annually, describing the hardship distributions made during the plan year.
The memorandum, including Attachment 1, can be found here: https://www.irs.gov/pub/foia/ig/spder/tege-04-0217-0008.pdf. It is important to review Attachment 1, as the attachment also contains information the employer or third party administrator should gather for each of the hardship requests.