Changes to 401(k) Hardship Distribution Rules
Individuals suffering from financial hardships have been provided with relief when seeking funds from their 401(k) plans. In addition to participant loans, many plans offer hardship distributions to ease the burden of adverse financial situations. The Bipartisan Budget Act of 2018 (BBA) changed the hardship distributions rules, providing access to additional funds in the participant’s account while limiting certain consequences of these distributions.
Treasury regulations state that a retirement plan may allow participants to receive hardship distributions from a plan due to an immediate and heavy financial need. The amount of the distribution must be limited to the amount necessary to satisfy that financial need and, prior to the BBA, limited to the participant’s deferrals, regular matching and regular profit-sharing contributions to the plan. In general, a distribution for an immediate and heavy financial need, as defined by income tax regulations, is one that is for:
- Medical expenses for participants, spouses, children and dependents
- Costs directly related to the purchase of a principal residence
- Tuition and related expenses
- Payments necessary to prevent eviction from a primary residence or for the foreclosure of mortgage on that residence
- Payments for funeral expenses
- Expenses for the repair or damage to a principal residence that would qualify for casualty loss deductions
Since hardship distributions are subject to income taxes, including, if applicable, the 10 percent penalty on early distributions, the requested amount may include amounts necessary to pay any associated income taxes including penalties and interest.
Until the BBA, a hardship distribution was not considered a heavy financial need until the participant exhausted all reasonable resources available to the employee, such as savings, distributions from other employee plans, loans from banks and loans from 401(k) plans. Also, the employee was not permitted to make elective deferrals to the plan for a period of six months after the hardship distribution.
To provide access to additional funds in times of need, the BBA changed the regulations to include qualified non-elective employer contributions and qualified matching contributions available for hardship distributions. Generally, these are employer contributions made to correct failed nondiscrimination tests. To limit the consequences associated with hardship distributions, the BBA now allows plans to permit the continuance of deferrals during the six-month period following the distribution. In addition, participants are no longer required to maximize plan loans before applying for the hardship distribution. Accordingly, administrators are no longer required to stop and start employee deferrals, track the six-month ineligibility period or determine whether the participant has maximized the use of all plan loans before taking the distribution. The changes are effective for plan years beginning after Dec. 31, 2018.
Hardship rules require that the employee exhaust funding from all other reasonable sources other than loans from 401(k) plans. To satisfy this rule, the plan must obtain a written statement from the participant stating that there are no other available resources such as liquidation of assets or commercial loans to take care of the hardship. The plan may accept this statement unless the employer has actual knowledge to the contrary. The hardship rules also require the amount be limited to the financial need. The participant must provide documents to support the dollar amount such as invoices, medical bills, real estate documents or tuition bills. Alternatively, the participant can provide a written summary of the information as long as the participant also agrees in writing that he or she will preserve the source documents and make them available at any time, upon request, to the employer or administrator.
If the plan’s third-party administrator (TPA) is also responsible for processing hardship distribution requests, the plan administrator should determine if the TPA is requesting and retaining the proper documents from the participant. The responsibility of all plan provisions, including hardship distributions, ultimately rests with the plan administrator. A best practice is to have the administrator retain copies of all documents relating to the hardship distribution, irrespective of the administrator’s perceived responsibility. This will ensure the documents are available and adequate in the event of an audit. Internal Revenue Manual section 4.72.2-1 provides further information and a comprehensive list of specific documents required for the substantiation of hardship withdrawals.
Proposed regulations would further modify the regulations governing the timing of the distributions; permit hardships for non-casualty repair of primary residences; and apply these rules to 403(b) arrangements.
Michael Gilchrist, CPA, is a senior manager at RotenbergMeril. He is a member of the NJCPA Accounting & Auditing Standards Interest Group and can be reached at email@example.com.
This article appeared in the January/February 2020 issue of New Jersey CPA magazine. Read the full issue.