The Internal Revenue Service has issued proposed regulations intended to amend the hardship distribution requirements applicable to 401(k) and 403(b) plans. The proposed regulations respond to questions raised by changes mandated by the Bipartisan Budget Act of 2018 and the Tax Cuts and Jobs Act of 2017. Overall, the proposed regulations would create a streamlined approach to handling hardship distributions from a 401(k) or 403(b) plan.
For a 401(k) or 403(b) plan to maintain its qualified status, distributions may be allowed only as permitted by the Internal Revenue Code. One available distribution is for certain hardships. A plan may allow an employee to take a hardship distribution where there is (1) an immediate and heavy financial need, and (2) the amount of the distribution is not in excess of the amount necessary to satisfy that need (plus any amounts necessary to pay taxes or penalties reasonably expected to result from the distribution). Historically, these determinations were made on a “facts and circumstances” basis, although the IRS did provide two safe harbors to ease administration. One safe harbor identifies six types of expenses that are deemed to constitute an immediate and heavy financial need. The other safe harbor identifies the conditions that apply to a distribution made to satisfy that immediate and heavy financial need. Under the second safe harbor, the IRS imposed two requirements:
- The employee had to obtain all currently available distributions and nontaxable loans from the plan and any other plan maintained by the employer, and
- The employee’s ability to make elective contributions to the plan (and any other plan maintained by the employer) had to be suspended for at least six months after receipt of the hardship distribution.
In addition, hardship distributions could be taken only from the employee’s elective deferrals, not earnings on those deferrals, safe harbor contributions, Qualified Matching Contributions, or Qualified Nonelective Contributions.
Last year Congress passed the Tax Cuts and Jobs Act of 2017, which increased the standard deduction for individuals while at the same time changing the availability of certain itemized deductions. A narrowing of the casualty loss deduction by the Tax Act has been considered by many to have an unintended impact on hardship distributions. That is because the safe harbor hardship distribution rules define a casualty loss in terms of the same Code section that provides a tax deduction for such a loss -- a safe harbor hardship distribution is available only for those casualty losses that qualify for the casualty deduction under Code section 165 (determined without regard to whether the loss exceeds 10 percent of adjusted gross income). Thus, historically, a qualifying hardship expense could relate to any type of uncompensated damage to the employee’s principal residence – for example, from a fire, storm, flood or isolated incident. Under the Tax Act, however, the casualty deduction under Code section 165 is limited to losses attributable to federally-declared disasters. Presumably, that meant the availability of safe harbor hardship distributions would have the same limitation. Because hardship distributions were not specifically discussed in the Tax Act, employers were left to wonder whether they could still provide a hardship distribution for a casualty loss caused by something other than a federally-declared disaster.
Then, earlier this year, Congress passed the Bipartisan Budget Act of 2018. The Budget Act, among other things, made changes to the hardship distribution requirements applicable to 401(k) and 403(b) plans. Specifically, Congress directed the IRS and the Department of Treasury to remove the six-month suspension-of-deferrals mandate required for a safe harbor hardship distribution. In addition, Congress removed the requirement that an employee obtain all available loans under the plan before taking a safe harbor hardship distribution. Finally, Congress expanded the potential source of a hardship distribution to include, at least for 401(k) plans, Qualified Matching Contributions, Qualified Nonelective Contributions, safe harbor contributions, and related investment earnings (including earnings on deferrals).
Although these changes are effective for plan years beginning January 1, 2019, employers were left with questions regarding how to implement these changes. For example, does an employer have the option of imposing a six-month suspension even though it is no longer legally required? What about hardship distributions taken in 2018, where the suspension would extend into 2019? Would the six-month suspension continue into 2019?
These burning questions and more are answered by the proposed regulations.
The proposed regulations would continue to allow an employer to use either a “facts and circumstances” analysis or the safe harbor list of expenses to determine the type of expense that will constitute an immediate and heavy financial need. The proposed regulations would, however, expand the list of available “safe harbor” expenses.
The second safe harbor (as well as any “facts and circumstances” analysis) would be replaced with a new overall streamlined process for identifying when a distribution is necessary to satisfy that immediate and heavy financial need. In addition, for 401(k) plans, the proposed regulations would follow the Congressional action and expand the pool of sources from which a hardship distribution may be taken to include amounts constituting safe harbor contributions, Qualified Matching Contributions and Qualified Nonelective Contributions, and earnings thereon (including earnings on elective deferrals). For 403(b) plans, hardship distribution sources would be limited to elective deferrals as well as Qualified Nonelective Contributions and Qualified Matching Contributions that are not in a custodial account. Earnings on elective deferrals, and on Qualified Nonelective Contributions and Qualified Matching Contributions in a custodial account, would not be available sources for a hardship distribution in a 403(b) plan.
Thus, under the proposed regulations, except as noted, a 401(k) or 403(b) plan would be able to permit hardship distributions as follows, effective January 1:
(1) Use either a “facts and circumstances” test or the IRS safe harbor to determine whether the expense is of the type that constitutes an immediate and heavy financial need. The available safe harbor expenses would include the following:
- Expenses for medical care
- Costs directly related to the purchase of a principal residence (excluding mortgage payments)
- Post-secondary education tuition, related educational fees, and room and board
- Payments necessary to prevent eviction or foreclosure of principal residence
- Burial or funeral expenses
- Casualty losses (the proposed regulations would clarify that this expense may be determined without regard to the limitation provided by the Tax Act)
- Expenses and losses incurred on account of a federally-declared disaster, provided the principal residence or principal place of employment of the employee at the time of the disaster was located in an area designated by the Federal Emergency Management Agency (this would be a new expense that was not previously authorized).
The medical care, tuition, and burial/funeral expenses would apply to employees, spouses, dependents and named beneficiaries under the plan.
(2) Use the following streamlined standard to determine whether the distribution is necessary to satisfy the above immediate and heavy financial need:
- The hardship distribution may not exceed the amount of an employee’s need, including any amounts necessary to pay any federal, state or local income taxes or penalties reasonably expected to result from the distribution, and
- The employee must have obtained other available distributions under the employer’s plans, and
- The employee must represent that he or she has insufficient cash or other liquid assets to satisfy the financial need. This requirement would be optional for hardship distributions taken on or after January 1, 2019, and mandatory for hardship distributions taken on or after January 1, 2020. Once an employee makes such a representation, the employer would be able to rely on it unless the employer had actual knowledge to the contrary.
What would change?
As noted above, the expanded list of safe harbor expenses would include expenses and losses related to federally-declared disasters. In addition, the proposed changes would allow employers to continue to use the broader definition of casualty loss that has historically applied. For those employers who have continued to follow the broader definition this year despite the changes promulgated by the Tax Act, the IRS advises that a retroactive plan amendment may be necessary.
In addition, the six-month suspension requirement under the second safe harbor would be removed, along with the requirement to first avail oneself of any available loans. Both of these changes would go into effect for hardship distributions made on or after January 1, 2019. For those safe harbor hardship distributions taken in the latter part of this year, the plan sponsor would be able to continue to require the six-month suspension through the remainder of the six-month period (i.e., continuing into 2019 as needed), or the plan sponsor would be able to cease the suspension effective January 1, 2019. As for whether plan sponsors would be able to keep the suspension requirement for hardship distributions beginning in 2019, the proposed regulations would say no; however, the mandatory prohibition would not begin until January 1, 2020, and would apply only to hardship distributions made on or after that date. Unlike the removal of the suspension requirement, plans would not have to remove the requirement to take any available loans before a hardship distribution – this change would be optional. However, employees would still be required to take all available taxable and nontaxable distributions (other than loans) from other employer plans, such as withdrawable after-tax and rollover contributions, before requesting a hardship distribution, and employers would be able to impose other conditions on employees before allowing a hardship distribution, so long as the six-month deferral suspension is not one of them.
Finally, as noted above, the proposed regulations would formally expand the sources available for hardship withdrawals. Effective in 2019, a plan would be able to allow employees to take hardship distributions from their employee deferrals to 401(k) plans as well as the earnings on those accounts. Such plans would also be able to allow hardship distributions from safe harbor contributions, Qualified Matching Contributions, and Qualified Nonelective Contributions, and any earnings on those accounts. This change would be optional – employers would be free to allow or not allow hardship distributions, and, if allowed, employers would be free to limit the sources of those distributions.
The IRS expects that employers with plans permitting hardship distributions will need to amend those plans to implement these new hardship distribution provisions. The deadline for amending plan documents to reflect these changes is tied to the issuance of an IRS Required Amendments List, which will mandate the necessary amendments. Because these are only proposed regulations, they have not been included on the IRS Required Amendments List, and there is no required amendment date yet. Once final regulations are issued and the changes are added to the IRS Required Amendments List, employers will have approximately two years to finalize their amendments. Of course, employers should look now at the changes they want to implement in 2019, ensure that they are operationally compliant, and anticipate any needed discretionary amendments.