The IRS has issued final regulations amending the hardship distribution rules for qualified retirement plans, including 401(k) and 403(b) plans. The final regulations are substantially similar to the proposed regulations that were issued in November 2018, but provide a few clarifications. Plans that have been complying with the proposed regulations will satisfy the final regulations. Below is a summary of the key changes and action items for plan sponsors.
Modifications to Safe Harbor List of Expenses
The final regulations modify the safe harbor list of expenses that are deemed to be made on account of an immediate and heavy financial need by:
- Adding that hardship distributions for qualifying medical, educational and funeral expenses will include those expenses incurred by a participant’s “primary beneficiary” under the plan;
- Clarifying that a hardship distribution relating to a home casualty loss does not have to result from a federally declared disaster; and
- Expanding the list of qualifying expenses to include expenses and losses incurred by the employee as a result of FEMA-declared disasters, provided that the participant’s principal residence or principal place of employment at the time of the disaster was located in the FEMA-designated disaster area.
Changes to the Rules for Determining Whether a Distribution Is Necessary
The final regulations eliminate the rules in the existing regulations (under which the determination of whether a distribution is necessary to satisfy a financial need is based on all the relevant facts and circumstances) and provide one general standard for determining whether a distribution is necessary. Under the final regulations, a distribution is treated as necessary to satisfy an immediate and heavy financial need of an employee only to the extent that:
- The amount of the distribution is not in excess of the amount required to satisfy the financial need (including any amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution);
- The employee has obtained all other currently available, non-hardship distributions under the plan and all other deferred compensation plans (qualified or nonqualified) maintained by the employer; and
- The employee has provided the plan administrator with a written representation that he or she has insufficient cash or other liquid assets reasonably available to satisfy the need (even if the employee does have cash or other liquid assets on hand, provided that those assets are earmarked to pay an obligation in the near future).
The plan administrator may rely on the employee’s representation, unless the plan administrator has actual knowledge that is contrary to the representation. In addition, the preamble to the final regulations clarifies that an employee’s representations may be made over the phone so long as the call is recorded.
Eliminating Suspensions of Contributions and Loan Requirements
The final regulations, consistent with the proposed regulations, also modify the safe harbor rules for determining whether the withdrawal is necessary to satisfy an immediate and heavy financial need by eliminating the following:
- The requirement that employee deferral contributions be suspended for at least six months following a hardship distribution. Plans may no longer impose a six-month contribution suspension on distributions made on or after January 1, 2020, but a plan may elect or may have already elected to eliminate the suspension as early as January 1, 2019 at its option; and
- The requirement to take plan loans, if available, prior to obtaining a hardship distribution. This is a permissive change meaning that plans may continue to require that a loan be taken out first (but are no longer obligated to do so).
The final regulations also clarify that the prohibition on suspensions applies only to a qualified plan, a Code Section 403(b) plan, and an eligible deferred compensation plan described in Code Section 457(b) maintained by a governmental employer. Plans subject to Code Section 409A may retain their suspension provisions.
Expanded Sources of Hardship Distributions
The final regulations, like the proposed regulations, expand the sources and type of contributions available for distribution to include qualified matching contributions (“QMACs”), qualified non-elective matching contributions (“QNECs”), and earnings on these amounts as well as earnings on elective contributions to 401(k) plans, regardless of when contributed or earned. The final regulations also clarify that safe harbor contributions made to a plan described in 401(k)(13) may be distributed on account of hardship. A plan may limit the type of contributions available for hardship and may exclude earnings on those contributions from hardship eligibility.
Under the final regulations, earnings on pre-tax deferrals made to a 403(b) plan continue to be ineligible for hardship distributions. In addition, the final regulations clarify that while QNECs and QMACs not held in a custodial account would be eligible for hardship distributions in a 403(b) plan, QNECs and QMACs that are held in a custodial account in a 403(b) plan continue to be ineligible for hardship distributions.
What Plan Sponsors Should Do Now
Individually designed 401(k) plans that currently permit hardship distributions will likely need to be amended to reflect the final regulations by December 31, 2021 (for calendar year plans) – but operational changes will be needed to comply with the new regulations by January 1, 2020. For preapproved 401(k) plans, the Treasury Department and IRS have extended the deadline for adopting an amendment to the 2020 tax-filing deadline plus extensions. For Code Section 403(b) plans, the deadline to adopt amendments to conform to the final regulations is March 31, 2020, but the final regulations state that this deadline could be extended.
Plan sponsors that previously amended their plans or changed their administrative practices to correspond with the proposed regulations should review prior plan amendments and current practices to confirm compliance with the final regulations.