Last November, the IRS issued proposed regulations incorporating several legislative changes regarding the ability of a 401(k) or 403(b) plan to make distributions to participants to relieve a hardship caused by an immediate and heavy financial need. Of course, whether a plan permits hardship distributions is up to the employer when designing the plan. Likewise, these changes give employers discretion in many areas to design their plan as to what, if any, hardship distributions will be allowed. These changes are described below.
Expansion of Safe Harbor Events. A plan can provide that an immediate and heavy financial need is determined under a facts and circumstances test or it can choose from among a list of safe harbor events that are deemed to meet the immediate and heavy financial need test. The proposed regulations address the expansion of the safe harbor events by adding three new events that qualify as of January 1, 2018.
- Primary Beneficiary. The qualifying medical, educational, and funeral expenses of the participant’s primary beneficiary under the plan has now been added to the safe harbor events to conform to a Pension Protection Act of 2006 change in the law. Previously such expenses were only included for the participant, spouses, children, and dependents.
- Casualty Deduction Limit Eliminated. Safe harbor events include expenses to repair damage to a participant’s principal residence that qualify as a casualty loss deduction under Internal Revenue Code Section 165. However, the 2017 Tax Act amended Section 165 to provide the deduction may only be taken if the participant’s home is in a federally declared disaster area. The proposed regulations clarify that this federally declared disaster restriction does not apply for purposes of the safe harbor.
- Federal Disasters. Added to the safe harbor list is expenses and loss of income resulting from a federally declared disaster when the participant lives or works in the disaster area.
Expansion of Sources of Distribution. Previously, hardship distributions could only be made from an employee’s elective deferrals under the plan and not even earnings on those deferrals. The proposed regulations permit hardship distributions to be made from earnings, QNECs, and QMACs of 401(k) plans beginning in 2019. However, for 403(b) plans, the restriction earnings remains and hardship distributions may only be made from QNECs and QMACs if they are held in custodial accounts. It should be noted that whether to allow distributions from these sources is discretionary, not required. Therefore, employers need to decide as a matter of plan design whether to permit them.
Relief Provisions. The proposed regulations also contain a number of relief provisions aimed at making the consequences of taking a hardship distribution less severe.
- Elimination of Six-Month Suspension. The proposed regulations eliminate the required suspension of the employee’s elective deferrals for six months following a hardship distribution. The suspension is prohibited for hardship distributions on or after January 1, 2020. For 2019, the employer may choose to remove the suspension and may do so retroactively for employers currently under the suspension period.
- Elimination of Loan Requirement. Previously to be eligible for a hardship distribution the employee must have first taken all available loans under the plan to try to relieve the financial need. This requirement may be eliminated beginning in the 2019 plan year. This too is not a required change but permissive.
- Substantiation. Beginning in 2020, when applying for a hardship distribution, the employee will have to represent that he or she has insufficient cash or liquid assets to satisfy the immediate and heavy financial need. Plan administrators may rely on such representation.
Plan Amendments. The IRS has requested comments on the proposed regulations within 60 days of their publication. They may change the proposed regulations before finalizing them. Plan documents will have to be amended to make any of the changes, however, the proposed regulations do not address when they will need to be made. The preamble only addresses individually designed plan by stating they must be amended after the changes appear on the IRS list of amendments.
Many employers use preapproved plans and the sponsor of these plans may adopt default provisions but allow adopting employers to opt out of the default to design their own changes. Employers need to decide whether they will make any optional changes and what needs to be done to implement required changes. Hardship distribution forms and procedures will likely need changing as well as the summary plan description.