IRS Relieves Some of the Hardship of Hardship Distributions

Spring 2017Articles For Your Benefit

As an exception to the general rule that elective deferral contributions to a 401(k) plan may not be withdrawn prior to termination of employment, attainment of age 59 1/2 or plan termination, a participant may request an earlier distribution of elective contributions, if the plan so permits, and if the distribution is taken to relieve financial hardship. A distribution is considered to be made on account of hardship only if the distribution is necessary to satisfy an “immediate and heavy financial need” of the participant.

Under the regulations, a distribution will be deemed to be on account of such a financial need, if it is for one or more of the following:

  • Expenses for medical care (deductible under Code Section 213(d)) for the plan participant or for the participant’s spouse, children, dependents or primary beneficiary under the plan;

  • Costs directly related to the purchase of a principal residence for the participant;

  • Payment of tuition, related educational fees, room and

    board expenses for up to the next 12 months of post-secondary education for the participant or for the participant’s spouse, children, dependents or primary beneficiary under the plan;

  • Payments necessary to prevent the eviction of the plan participant from his or her primary residence or foreclosure of the mortgage on that residence;

  • Payment for burial or funeral expenses for the participant’s deceased parents, spouse, children, dependents or primary beneficiary under the plan; or

  • Expenses for the repair of damages to the participant’s principal residence that would qualify for the casualty deduction under Code Section 165.

A distribution is deemed to be necessary to satisfy the financial need if (1) the participant has obtained all other currently available distributions and non-taxable loans under the plan and all other plans maintained by the employer, and (2) the participant is prohibited, under the terms of the plan, from making elective deferral contributions and other employee contributions to the plan (and all other plans maintained by the employer) for a period of at least six months after receipt of the distribution.

Some plans mandate detailed documentation to support each hardship withdrawal request, while others dictate only that participants self-certify the existence and general nature of the hardship. Certainly, securing appropriate documentation, such as a copy of a foreclosure or eviction notice, is best practice. In many cases, however, plan administrators feel that requesting full documentation may intrude upon the privacy of employees. Additionally, providing full documentation can be cumbersome in situations in which withdrawal applications are submitted and processed electronically or telephonically.

Earlier this year, the IRS issued a memorandum setting forth substantiation guidelines to be followed by IRS auditors when examining plans and evaluating whether a 401(k) hardship distribution is deemed to be on account of an immediate and heavy financial need. A subsequent memorandum confirmed that the guidance also applies to hardship withdrawals from 403(b) plans.

Obviously, an auditor will start by reviewing the source documents or the summary of the information obtained from the source documents to determine whether they substantiate the existence of an immediate financial need. The guidelines make it clear, however, that when a plan administrator relies upon a summary of information in source documents, rather than on source documents themselves, additional requirements apply:

First, the plan administrator must provide notice to the participant of the following: (1) the hardship distribution is taxable and additional (early distribution excise) taxes may apply; (2) the amount of the distribution may not exceed the immediate and heavy financial need; and (3) the hardship distribution may be made only from the principal amount of elective contributions (i.e., no hardship distributions may be made from earnings on elective contributions or from qualified non-elective or qualified matching contribution accounts).

Second, the participant must agree to preserve source documents and to make them available at any time upon request of the employer or plan administrator.

Third, the plan administrator should assure that the summary of information from source documents contains the following specific information enumerated in an attachment to the IRS memorandum, and to be taken into consideration by an IRS auditor, in determining whether the existence of financial hardship has been substantiated:

General Information for All Hardship Requests

  • Participant’s name

  • Total cost of the event causing hardship (for example, total cost of medical care, total cost of funeral/ burial expenses, payment needed to avoid foreclosure or eviction)

  • Amount of distribution requested

  • Certification by the participant that the information provided is true and accurate

Specific Information on Deemed Hardship for Medical Care

  • Who incurred the medical
    expenses (name)?

  • What is the relationship to the participant (self, spouse, dependent or primary beneficiary under the plan)?

  • What was the purpose of the medical care (not the actual condition but the general category of expense, for example, diagnosis, treatment, prevention, associated transportation, long-term care)?

  • Name and address of the service provider (hospital, doctor/dentist/ chiropractor/other, pharmacy)

  • Amount of medical expenses not covered by insurance

Specific Information on Deemed Hardship for Purchase of Principal Residence

  • Will this be the participant’s principal residence?

  • Address of the residence

  • Purchase price of the principal residence

  • Types of costs and expenses covered (down payment, closing costs and/or title fees)

  • Name and address of the lender

  • Date of the purchase/sale agreement

  • Expected date of closing

Specific Information on Deemed Hardship for Educational Payments

  • Who are the educational payments for (name)?

  • What is the relationship to the participant (self, spouse, child, dependent or primary beneficiary under the plan)?

  • Name and address of the educational institution

  • Categories of educational payments involved (post high school tuition, related fees, room and board)

  • Period covered by the educational payments (beginning/end dates of up to 12 months)

Specific Information on Deemed Hardship for Foreclosure/Eviction from Principal Residence

  • Is this the participant’s principal residence?

  • Address of the residence

  • Type of event (foreclosure or eviction)

  • Name and address of the party that issued the foreclosure or eviction notice

  • Date of the notice of foreclosure or eviction

  • Due date of the payment to avoid foreclosure or eviction

Specific Information on Deemed Hardship for Funeral and Burial Expenses

  • Name of the deceased

  • Relationship to the participant (parent, spouse, child, dependent or primary beneficiary under the plan)

  • Date of death

  • Name and address of the service provider (cemetery, funeral home, etc.)

Specific Information on Deemed Hardship for Repair of Damage to Principal Residence

  • Is this the participant’s principal residence?

  • Address of the residence that sustained damage

  • Briefly describe the cause of the casualty loss (fire, flooding, type of weather-related damage, etc.), including the date of the casualty loss

  • Briefly describe the repairs, including the date(s) of repair (in process or completed)

This list of required information is included in an attachment to the IRS guidelines. We would recommend that plan administrators allowing substantiation through a summary of information provide the substantiation listing to participants in advance so as to enable them to assure that the summary contains the requisite information.

Apart from the documentation, the IRS memorandum directs auditors to carefully scrutinize situations in which employees have received more than two hardship distributions in a single plan year. With this in mind, employers may wish to limit the frequency with which hardship withdrawal is allowed.

Overall, the guidelines provide some flexibility to employers and plan administrators by allowing them to rely on summaries rather than requiring actual source documents in all cases. However, while employers and plan administrators often are reluctant to impose additional burdens on individuals who are experiencing financial difficulties, it is clear that self-certification of a hardship, without the necessary information and/or source documents, will not suffice and will result in a plan failure.