401(K) Hardship Distribution Rules Final Regs Modified, Clarified

NSTPInternal Revenue Service (IRS)

401(K) Hardship Distribution Rules Final Regs Modified, Clarified

401(K) Hardship Distribution Rules Final Regs Modified, Clarified

The IRS has issued final regs that amend the rules for hardship distributions from a Code Sec. 401(k) hardship distribution plan. The final regs are substantially similar to the proposed regs issued in November 2018 and plans that complied with the proposed regs will satisfy the final regs.

Background. 401(k) plans may provide that an employee can receive a distribution of elective contributions from the plan on account of hardship. (Reg. § 1.401(k)-1(d)(3)) In general, a retirement plan can make a hardship distribution only: if the plan permits such distributions; because of an immediate and heavy financial need of the employee; and in an amount necessary to meet the financial need. In general, the question of whether an employee had an immediate and heavy financial need was based on all relevant facts and circumstances. A financial need could be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee. (Reg. § 1.401(k)-1(d)(3)(iii)(A) before amendment by TD 9875)

Under a safe harbor, a distribution was made on account of an immediate and heavy financial need if made for one of a number of specified expenses, including those to repair damage to the employee's principal residence that "would qualify for the casualty deduction under Code Sec. 165 (determined without regard to whether the loss exceeds 10% of adjusted gross income)". (Reg. §1.401(k)-1(d)(3)(iii)(B) prior to amendment by TD 9875)

Also, a distribution was deemed necessary to satisfy an immediate and heavy financial need if certain requirements were met including that, after the hardship distribution was received, the employee could not make elective contributions or employee contributions to the plan and all other plans maintained by the employer for at least six months (6-month suspension requirement). (Reg. § 1.401(k)-1(d)(3)(iv)(E) prior to amendment by TD 9875) The maximum amount that could be distributed on account of hardship was the total of the employee’s elective contributions not previously distributed (plus earnings, qualified nonelective contributions (QNECs) and qualified matching contributions (QMACs) credited before a specified grandfather date. (Reg. § 1.401(k)-1(d)(3)(ii) prior to amendment by TD 9875)

Under Code Sec. 403(b)(11), contributions made pursuant to a salary reduction agreement (403(b) elective deferrals) may be distributed only on or after the occurrence of certain events, one of which is the employee’s hardship. Code Sec. 403(b)(11) also provides that no income attributable to these contributions may be distributed on account of hardship.

Reg. § 1.403(b)-6(d)(2) provides that a hardship distribution of 403(b) elective deferrals is subject to the rules and restrictions set forth in Reg. §1.401(k)-1(d)(3) and is limited to the aggregate dollar amount of a participant’s 403(b) elective deferrals, without earnings thereon.

Background—statutory changes in BBA, TCJA, etc. There have been a number of statutory changes affecting 401(k) plans that are not reflected in the old regs, including:

  • The Bipartisan Budget Act of 2018 (BBA; P.L. 115-123) directs IRS to modify Reg. § 1.401(k)-1(d)(3)(iv)(E), within one year from February 9, 2018, to delete the 6-month prohibition on contributions and to make “any other modifications necessary to carry out the purposes of” Code Sec. 401(k)(2)(B)(i)(IV). The revised regs are to apply to plan years beginning after December 31, 2018.
  • The BBA added Code Sec. 401(k)(14)(A), which states that the maximum amount available for distribution upon hardship includes (i) contributions to a profit sharing or stock bonus plan to which Code Sec. 402(e)(3) applies, (ii) QNECs, (iii) QMACs, and (iv) earnings on these contributions.
  • The BBA also added Code Sec. 401(k)(14)(B), which 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.
  • The Tax Cuts and Jobs Act (TCJA; P.L. 115-97) added Code Sec. 165(h)(5), which, from 2018 through 2025, limits the deduction for a personal casualty loss to the extent that the loss is attributable to a federally declared disaster.

Final regs. The final regs amend the existing Code Sec. 401(k) and Code Sec. 401(m) regs to reflect the statutory changes to Code Sec. 401(k) and Code Sec. 401(m). The final regs are substantially similar to the proposed regs issued in November 2018 and plans that complied with the proposed regs will satisfy the final regs.

Deemed Immediate and Heavy Financial Need. The final regs modify the safe harbor list of expenses in existing Reg. §1.401(k)-1(d)(3)(iii)(B) and distributions for these safe harbor expenses are deemed to be made for an immediate and heavy financial need. The final regs modify existing Reg. §1.401(k)-1(d)(3)(iii)(B) by:

  1. Adding the "primary beneficiary under the plan" as an individual for whom qualifying medical, educational, and funeral expenses may be incurred;
  2. Modifying existing Reg §1.401(k)-1(d)(3)(iii)(B)(6) (relating to damage to a principal residence that would qualify for a casualty deduction under Code Sec. 165) to provide that the limitations in Code Sec. 165(h)(5) do not apply to hardship distributions; and
  3. Adding a new type of expense to the list relating to expenses incurred because of certain disasters. (Reg. §1.401(k)-1(d)(3)(iii)(B))

Distribution Necessary to Satisfy Financial Need. The final regs modify the rules for determining whether a distribution is necessary to satisfy an immediate and heavy financial need by eliminating any requirement that an employee

  1. Be prohibited from making elective contributions and employee contributions after receiving a hardship distribution, and
  2. Must take plan loans before taking a hardship distribution. (Preamble; Reg. §1.401(k)-1(d)(3)(iv)(E))

Specifically, the final regulations eliminate the existing safe harbor in Reg. §1.401(k)-1(d)(3)(iv)(E), under which a distribution is deemed necessary to satisfy the financial need only if elective contributions and employee contributions are suspended for at least 6 months after a hardship distribution is made and, if available, nontaxable plan loans are taken before the hardship distribution is made.

The final regs also eliminate the relevant facts and circumstances test for determining whether a distribution is necessary to satisfy a financial need and provide one general standard for determining whether a hardship distribution is necessary. (Reg. §1.401(k)-1(d)(3)(iv)(B)) Under this general standard:

  1. A hardship distribution may not exceed the amount of an employee’s “financial needs,” including any amounts needed to pay any federal, state or local income taxes or penalties reasonably anticipated to result from the distribution;
  2. The employee must have taken other available, non-hardship distributions under the employer’s plans; and
  3. The employee must provide a representation that he or she has insufficient cash or other liquid assets reasonably available to satisfy his or her financial need. (Reg. §1.401(k)-1(d)(3)(iv)(B))

The final regs provide that the employee representation only relates to whether the employee has cash or other liquid assets that are "reasonably available" to satisfy an immediate and heavy financial need. Thus, an employee could make a representation that he or she has insufficient cash or other liquid assets reasonable available to satisfy an immediate and heavy financial need even if the employee did have cash or other liquid assets on hand. (Preamble; Reg. §1.401(k)-1(d)(3)(iv)(B))

The proposed regs provided that the employee representation could be made "in writing, by an electronic medium, or in such other form prescribed by the Commissioner." (Preamble to Prop Reg REG-107813-18) The final regs clarify that a verbal representation via a recorded telephone call is an acceptable method of making an employee representation because it fits the definition of electronic medium in Reg. §1.401(a)-21(e)(3). (Preamble)

A plan administrator who has actual knowledge that is contrary to the employee’s representation may not allow a hardship distribution. (Reg. §1.401(k)-1(d)(3)(iv)(B)) The final regs clarify that this requirement does not impose on plan administrators an obligation to inquire into the financial condition of an employee who seeks a hardship distribution. Rather, the rule is limited to situations in which the plan administrator already possesses sufficiently accurate information to determine the veracity of an employee representation. (Preamble)

The final regs also clarify that generally a plan may impose additional conditions on an employee who wants to take a hardship distribution such as completing an application process and providing certain documentation. However, the final regs do not permit a plan to provide for a suspension of elective contributions or employee contributions as a condition of obtaining a hardship distribution. (Preamble; Reg. §1.401(k)-1(d)(3)(iv)(E))

The final regs clarify that the prohibition on suspension of elective contributions or employee contributions as a condition of obtaining a hardship distribution applies only to a qualified plan, a Code Sec. 403(b) plan, and an eligible deferred compensation plan under Code Sec. 457(b) maintained by an eligible employer. Thus, a plan subject to Code Sec. 409A may retain its suspension provisions or the plan may be amended to remove them. (Preamble)

Under the final regs if, on or after January 1, 2020, matched employee contributions are distributed in conjunction with a hardship distribution of elective contributions, a suspension of employee contributions is not permitted. (Preamble)

Expanded Sources for Hardship Distributions . The final regs permit hardship distributions from Code Sec. 401(k) plans of elective contributions, QNECs, QMACs and earnings on these amounts, regardless of when contributed or earned. (Reg. §1.401(k)-1(d)(3)(ii))

Safe harbor contributions made to a plan described in Code Sec. 401(k)(13) may also be distributed on account of an employee’s hardship because these contributions are subject to the same distribution limitations applicable to QNECs and QMACs. (Reg. §1.401(k)-3(k)(3)(i)) However, a plan may limit the type of contributions available for hardship distributions and may exclude earnings on those contributions from hardship distribution eligibility. (Preamble)

Section 403(b) Plans. Reg. §1.403(b)-6(d)(2) provides that a hardship distribution of 403(b) elective deferrals is subject to the rules and restrictions set forth in Reg. §1.401(k)-1(d)(3). Accordingly, the preamble to the proposed regulations stated that the new rules for hardship distribution of elective contributions from a 401(k) plan generally apply to 403(b) plans. This requirement is retained in the final regulations and, therefore, it applies to 403(b) plans. (Preamble; Reg. §1.401(k)-1(d)(3)(iii)(B))

The final regs also provide that amounts attributable to QNECs and QMACs may be distributed from a 403(b) plan on account of hardship only to the extent that hardship is a permitted distribution event for amounts that are not attributable to 403(b) elective deferrals. Thus, QNECs and QMACs in a 403(b) plan that are not in a custodial account may be distributed on account of hardship, but QNECs and QMACs in a 403(b) plan that are in a custodial account continue to be ineligible for distribution on account of hardship. (Preamble)

Applicability Dates. The final regs provide that Reg. §1.401(k)-1(d)(3) applies to distributions made on or after January 1, 2020, rather than, as in the proposed regs, to distributions made in plan years beginning after December 31, 2018. However, Reg. §1.401(k)-1(d)(3) may be applied to distributions made in plan years beginning after December 31, 2018, and the prohibition on suspending an employee’s elective contributions and employee contributions as a condition of obtaining a hardship distribution may be applied as of the first day of the first plan year beginning after December 31, 2018, even if the distribution was made in the prior plan year.

If the choice is made to apply Reg. §1.401(k)-1(d)(3) to distributions made before January 1, 2020, the new rules requiring an employee representation and prohibiting a suspension of contributions may be disregarded with respect to those distributions. To the extent early application of Reg. §1.401(k)-1(d)(3) is not chosen, the rules in Reg. §1.401(k)-1(d)(3), prior to amendment by TD 9875, apply to distributions made before January 1, 2020, taking into account statutory changes effective before 2020 that are not reflected in that regulation.

In addition, the revised list of safe harbor expenses may be applied to distributions made on or after a date that is as early as January 1, 2018. Thus, for example, a plan that made hardship distributions relating to casualty losses deductible under Code Sec. 165 without regard to the changes made to Code Sec. 165 by the TCJA may be amended to apply the revised safe harbor expense relating to casualty losses to distributions made in 2018, so that plan provisions will conform to the plan’s operation. Similarly, a plan may be amended to apply the revised safe harbor expense relating to losses (including loss of income) incurred by an employee on account of a disaster that occurred in 2018, provided that the employee’s principal residence or principal place of employment at the time of the disaster was located in an area designated by the Federal Emergency Management Agency for individual assistance with respect to the disaster.

Plan Amendments. The IRS expects that plan sponsors will need to amend their plans’ hardship distribution provisions to reflect the final regs, and any such amendment must be effective for distributions beginning no later than January 1, 2020. The deadline for amending a disqualifying provision is set forth in Rev Proc 2016-37, 2016-29 IRB 136. For example, with respect to an individually designed plan that is not a governmental plan, the deadline for amending the plan to reflect a change in qualification requirements is the end of the second calendar year that begins after the issuance of the Required Amendments List (RAL) described in section 9 of Rev Proc 2016-37 that includes the change; if the final regs are included in the 2019 RAL, the deadline will be December 31, 2021.

A plan provision that does not result in the failure of the plan to satisfy the qualification requirements, but is integrally related to a qualification requirement that has been changed in a manner that requires the plan to be amended, may be amended by the same deadline that applies to the required amendment. Thus, in the case of an individually designed plan, the deadline for such an integrally related amendment will be the same as the deadline for the required amendment even if some of the amendment provisions have an earlier effective date.

The IRS recognizes that, for an employer using a pre-approved plan, the interim amendment deadline under Rev Proc 2016-37 that applies for an amendment to a plan provision that is integral to the qualification requirement that has been changed may be earlier than the interim amendment deadline for the required amendment. Accordingly, the IRS is extending the deadline for an interim amendment related to the hardship distribution provisions. Under this extension, for an employer using a pre-approved plan, the interim amendment deadline for the required amendment to the hardship distribution provisions of the plan will also be the deadline for all amendments integrally related to the hardship distribution provisions (rather than the earlier deadline that might otherwise apply under Rev Proc 2016-37 to those integrally related amendments).