Reviewing Administration of Retirement Plan Hardship Withdrawals

This a friendly reminder for plan sponsors: even if your 401(k) or 403(b) plan’s third-party administrator (TPA) handles participant transactions, you’re still ultimately responsible for the proper administration of hardship withdrawals and plan loans (considerations related to plan loan compliance are discussed here). In light of the IRS guidance that has been issued over the past year or so, as well as recent legislative changes concerning administration and documentation of hardship withdrawals, we’ve compiled a non-exhaustive list of issues to consider if your plan permits hardship withdrawals:

Is your documentation accurate?

Periodically review the terms of the plan regarding hardship withdrawals, any explanation of hardship withdrawals in the plan’s summary plan description, and the hardship withdrawal forms used by your TPA to ensure that the rules for hardship withdrawals are described accurately.

What is your TPA’s documentation process?

Confirm with the plan’s TPA that a process is in place to request proper documentation from participants to substantiate a hardship distribution, and also that a process is in place to retain this documentation (in paper or electronic format).

Note that proper documentation is required even if the plan follows the safe harbor standards for hardship withdrawals as set out in the regulations under Code §401(k) (“Safe Harbor Hardship Withdrawals”). The IRS recently updated its Internal Revenue Manual (IRM) to include substantiation guidelines issued in 2017 for auditors examining whether a Safe Harbor Hardship Withdrawal is “deemed to be on account of an immediate and heavy financial need.” While the IRM is not formal guidance, it reiterates the importance of requesting and retaining participants’ substantiation of the need for a hardship withdrawal, because the IRS is likely to ask for this information on audit.

Consistent with the guidelines in the IRM, the plan’s TPA should be taking the following steps when reviewing participant hardship withdrawal requests:

• Require participants to provide either source documents to support the hardship withdrawal request (e.g., estimates, contracts, bills and statements from third parties) or a summary of the source documentation.
• If summary information is accepted, the summary information provided should include:
  • The participant’s name;
  • The total cost of the hardship event;
  • The amount of hardship withdrawal requested;
  • The specific information listed in the IRM depending on the type of hardship; and
  • Certification by the participant that the information provided is true and accurate.
• In addition, if summary information is accepted the participant should be notified that:
  • The hardship withdrawal is taxable and additional taxes could apply;
  • The amount of the withdrawal cannot exceed the immediate and heavy financial need; and
  • Hardship withdrawals cannot be made from earnings on elective contributions or from qualified nonelective (QNEC) or qualified matching contribution (QMAC) accounts (if applicable after taking into account the Bipartisan Budget Act change discussed below); and
  • The participant is required to preserve source documents and to make them available at any time, upon request, to the plan sponsor or TPA.
• Finally, if summary information is accepted, the TPA should be required to provide reports to the plan sponsor at least annually or otherwise allow the plan sponsor access to data regarding hardship withdrawals

Plan sponsors may want to consider that, while summary documentation might be convenient, plan sponsors will then be relying on participants to retain source documentation which might be requested by the IRS on audit.

How will your TPA change its hardship withdrawal review procedures in light of recent legal changes?

Both the Tax Cuts and Jobs Act and the Bipartisan Budget Act include changes that impact hardship withdrawals. Plan sponsors should discuss with their plans’ TPAs what changes will be made to hardship withdrawal administration in light of these changes in the law.

Tax Cuts and Jobs Act

Effective January 1, 2018, the casualty loss deduction available to taxpayers is restricted to those losses attributable to a federally declared disaster. This means that Safe Harbor Hardship Withdrawals to pay expenses to repair a participant’s principal residence for deductible casualty loss damage are limited to circumstances in which the property damage results from a federally declared disaster.

Note: This change impacts hardship withdrawals from any plan that uses the casualty loss deduction as a determination of hardship (i.e., plans that fully incorporate the Safe Harbor Hardship Withdrawal rules). These plans should be reviewed to confirm whether an amendment is needed (e.g., an amendment might be needed if the decision is made to depart from the Safe Harbor Hardship Withdrawal rules for casualty loss hardship, in order to have more flexibility to approve hardship withdrawals due to casualty losses other than those attributable to federally declared disasters).

Bipartisan Budget Act

Effective for plan years beginning after December 31, 2018, the following changes to the hardship withdrawal rules apply:

• Participants will no longer be required to exhaust the opportunity to take loans under the plan (or presumably other plans of the same employer) before receiving a hardship withdrawal.
• Participants will be permitted to take hardship withdrawals from the participant’s elective deferral contributions, QNECs, QMACs and earnings (including post-1988 earnings on elective deferrals).
  Note: It is unclear whether this change will apply to Code §403(b) plans, since the §403(b) regulations incorporate the §401(k) regulations by reference but (i) specifically limit hardship distributions to elective deferrals, and (ii) prohibit hardship withdrawals of income attributable to elective deferrals from a §403(b) plan annuity contract. Sponsors of §403(b) plans may want to wait for additional IRS guidance before implementing this change.
• The Treasury Secretary is directed to remove from the Safe Harbor Hardship Withdrawal rules the requirement that the participant’s deferral contributions to all plans maintained by the employer must be suspended for six months following the withdrawal.

Note: More guidance is needed on these changes – including whether a plan sponsor can continue to rely on the Safe Harbor Hardship Withdrawal rules without amending its plan to provide for the above changes, and how the elimination of the six-month suspension requirement will apply to a participant who is in the middle of a suspension period when the changes become effective.

To the extent plan amendments are needed, sponsors of individually designed plans will have until the end of the plan’s remedial amendment period (two years after the changes are listed on the IRS Required Amendment List) to adopt such amendments.

Has your plan implemented any of the relief provisions granted with respect to hardship withdrawals for participants affected by natural disasters in 2017?

If so, review whether the plan document (or the plan’s hardship withdrawal procedures) needs to be amended for this relief, described briefly below:

Bipartisan Budget Act Relief

Applies to “qualified individuals” – participants who sustained an economic loss due to Hurricanes Harvey, Irma or Maria, or due to the California wildfires, whose principal place of abode was located in the disaster area on the applicable date(s) specified in the Bipartisan Budget Act, and who request plan distributions during the applicable time period(s) covered by the relief. The relief permits a qualified individual to take a distribution of up to $100,000 (in total from all the participant’s 401(k), 403(b) and 457(b) plan accounts and IRAs), regardless of the reason for the distribution. In addition, the participant is not required to have taken all plan loans or other available distributions, and special taxation and recontribution rules apply. Additional relief applies to participants who took plan withdrawals to purchase or construct a principal residence in one of the disaster areas during the applicable time period(s) covered by the relief.

Plans are not required to offer this special disaster relief, but if the relief is provided, plans must be amended by the last day of the first plan year beginning on or after January 1, 2019 (January 1, 2021 for governmental plans).

IRS Relief

Applies to qualified individuals, as well as participants whose place of employment was in the disaster area or whose child, parent, grandparent or other dependent lived or worked in the disaster area on the applicable date(s) specified in the IRS relief guidance, and who take hardship withdrawals during the applicable time period(s) covered by the relief. The relief allowed plans to permit withdrawals for reasons beyond the Safe Harbor Hardship Withdrawal reasons, but did not relax the requirement for a participant to take all plan loans and other available distributions before receiving a hardship withdrawal.

If the plan did not include a hardship withdrawal provision but provided for these withdrawals in accordance with the relief, the plan must be amended by the last day of the plan year that begins after December 31, 2017. Otherwise, plans do not have to be amended to provide this relief.