Note: This article is a revised version of an article published by our law firm years ago. It has been updated to reflect statutory changes under the Bipartisan Budget Act of 2018 (BBA) and proposed hardship distributions regulations published on November 14, 2018.
What do you do when a participant requests a hardship distribution from your company’s 401(k) plan? While you no doubt want to comply with the participant’s request, you don’t want to do so to the detriment of your plan. It’s critical to understand what the law allows and to review your plan’s hardship distribution provisions in order to avoid the headaches that will result from impermissible hardship distributions.
The Hardship Distribution Rules
The Code allows hardship distributions from 401(k) plans to participants who are still actively employed by the plan sponsor, even if they are under age 59-1/2, subject to certain requirements set forth in the Treasury regulations. (Although hardship distributions may also be available from 403(b) plans and unforeseeable emergency distributions may be available from 457(b) plans and 409A plans under somewhat different terms, our focus is on 401(k) plans.) Why is the proper review and handling of hardship distributions critical? If a plan makes an impermissible hardship distribution, the worst-case headache is plan disqualification.
The first requirement is that the distribution be made on account of an immediate and heavy financial need of the participant. This determination is based on the facts and circumstances of each situation. The regulations provide that the need to pay the funeral expenses of a family member would constitute an immediate and heavy financial need, but the purchase of a boat or television would “generally” not (one wonders when purchasing a boat or a television might qualify!). Interestingly, a financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the participant. The regulations also provide a list of expenses that are deemed to be on account of an immediate and heavy financial need. Regulations expanding this list have been proposed and may be applied to hardship distributions as early as January 1, 2018.
The second requirement is that the hardship distribution must not exceed the amount necessary to satisfy the financial need (including taxes on the hardship distribution). Under the regulations in effect before the proposed regulations, a distribution was not treated as necessary to satisfy the financial need to the extent that the need may be relieved by other resources reasonably available to the participant (including the assets of the participant’s spouse and perhaps minor children!). Under the proposed regulations, the participant must have obtained all other currently available distributions under the 401(k) plan and all other plans of deferred compensation (whether qualified or nonqualified) maintained by the employer. They also require, effective for distributions made on or after January 1, 2020, that the participant represent that he or she has insufficient cash or other liquid assets to satisfy the need. The plan administrator can rely on this representation unless the plan administrator has actual knowledge to the contrary.
The proposed regulations allow a plan to provide for additional conditions to demonstrate that the requested distribution is necessary to satisfy the financial need. Interestingly, they permit a plan to require that the participant must obtain all nontaxable loans available under the 401(k) plan and all other plans maintained by the employer, even though the BBA added section 401(k)(14)(B) to the Code that provides that a distribution is not treated as failing to be made upon the hardship of an employee solely because the employee does not take any available loan under the plan. However, for distributions made on or after January 1, 2020, a plan may not provide for a suspension of a participant’s elective contributions or employee contributions as a condition of obtaining a hardship distribution (contrary to a safe harbor contained in the regulations in effect before the proposed regulations).
The BBA also added section 401(k)(14)(A) to the Code effective for plan years beginning after December 31, 2018. It provides that the maximum amount available for a hardship distribution includes (i) contributions to a profit-sharing or stock bonus plan to which Code section 402(e)(3) applies (regarding cash or deferred arrangements), (ii) qualified nonelective contributions (QNECs), (iii) qualified matching contributions (QMACs), and (iv) earnings on these contributions. Consistent with this statutory change, the proposed regulations will eliminate the prohibition against a hardship distribution including such amounts that are contained in the existing regulations.
What Does Your Plan Allow?
If a plan is going to allow for hardship distributions, the plan document must expressly provide for them. Although the plan will have to grant discretion to the plan administrator to determine whether the claimed hardship qualifies for a distribution, that discretion must be guided by nondiscriminatory and objective standards set forth in the plan.
Both the current and the proposed regulations contain certain safe harbor standards, the satisfaction of which will be deemed to be the satisfaction of the relevant hardship distribution requirement. Does your plan use these safe harbors? Many plans do; however, plan administrators of such plans need to understand whether those plan provisions are merely a safe harbor under the plan or whether they are absolute requirements under the plan (i.e., no hardship distribution will be made unless it fits under the safe harbors).
What Procedures Are You Following?
If the plan document provides for hardship distributions, the main traps for the unwary plan administrator are the failure to follow the terms of the plan and the failure to adequately document the decision to grant (or deny) the request for a hardship distribution. Your documentation of each decision should include the participant’s application with the participant’s representations as to the hardship involved and the amount needed to satisfy the financial need, your determination regarding whether the requirements in the regulations have been satisfied, and your determination whether the requirements in the plan document have been satisfied. Sloppy documentation and inconsistent or overly liberal distributions may result down the road in the need for corrections under the IRS’s Employee Plans Compliance Resolution System (i.e., the Voluntary Correction Program (VCP), the Self-Correction Program (SCP), or the Audit Closing Agreement Program (Audit CAP)) in order to avoid plan disqualification.
What To Do?
You should review your plan’s hardship distribution provisions in light of the statutory changes and the proposed regulations, modify them if necessary to maintain the qualified status of your plan, modify them if appropriate to reflect how you want your plan’s hardship distribution provisions to work, and make certain that you are following them in responding to any request for a hardship distribution. A little preventive maintenance now can avoid headaches down the road. Also, keep watch for the finalization of the proposed regulations and how they differ, if at all, from the proposed regulations.