Benefits and Compensation

Proposed IRS Hardship Distribution Regulations Change Standard for Determination

The Internal Revenue Service (IRS) has proposed regulations that would change the rules for hardship distributions from 401(k) and 403(b) retirement plans by replacing the facts-and-circumstances test for determining hardship eligibility with a three-part general standard.

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The general standard should streamline administration of hardship distributions, and may encourage some plans to allow hardship distributions for reasons other than the pre-approved safe harbors.

The current hardship distribution rules allow participants in these plans who experience an immediate and heavy financial need access to their retirement account balances while still employed and before they reach age 59½. Hardship distributions are includable in income and are usually subject to a 10-percent early withdrawal penalty, unless an exception applies.

The proposed regulations, published November 14 (83 Fed. Reg. 56763), implement changes made to the Internal Revenue Code by the Tax Cuts and Jobs Act (TCJA) signed into law December 22, 2017, and the Bipartisan Budget Act (Budget Act) signed February 9, 2018, as well as certain provisions of previous enactments and guidance.

Most of the changes are effective January 1, 2019. The proposed regulations also would create new rules that would be mandatory for hardship distributions made after January 1, 2020, but offer some optional provisions that could be made for the 2018 or 2019 plan years.

New Standard for Hardships

Under current regulations, plan administrators must take into account all relevant facts and circumstances to determine whether a hardship distribution is necessary to satisfy an immediate and heavy financial need. The proposed regulations would replace that test with a three-part general standard:

  1. A hardship distribution must not exceed the amount of an employee’s need, (including any amounts necessary to pay any taxes or penalties reasonably anticipated to result from the distribution).
  2. The employee already must have obtained any other available distributions under the employer’s plans (besides other hardship distributions or loans.
  3. The employee must represent that he or she has insufficient cash or other liquid assets to satisfy the financial need. Consistent with the current standard, a plan administrator will be allowed to rely on a participant’s representation of the need unless the plan administrator has actual knowledge to the contrary.

Plan administrators may begin applying this general standard on and after January 1, 2019, except that the third requirement (the participant’s representation) will not become mandatory until January 1, 2020 (for hardship distributions made on or after that date).

Deferral Suspension Prohibited

Another important change: The current regulations require the elimination of the current requirement that participants be suspended from making deferral elections for a period of 6 months following a hardship distribution. The Budget Act directed the IRS to remove this 6-month suspension requirement, but the proposed regulations go further and actually prohibit plans from suspending participants from making deferral contributions following a hardship distribution.

After the Budget Act was passed, some plan sponsors had contemplated whether they could continue to suspend participants, even though they would be no longer required to do so. If the proposed regulations become final, beginning with hardship distributions made on or after January 1, 2020, plans would be prohibited from implementing any deferral suspension period.  The preamble explains that Congress wanted participants to have the opportunity to replace the funds that are withdrawn by a hardship distribution.

Plan sponsors and administrators also have been struggling with how to apply the 6-month suspension rule to hardship distributions that were made in the second half of 2018. Although the suspension was mandatory when originally imposed, the Budget Act requires that it be removed effective January 1, 2019.

The preamble of the proposed regulations provides much-needed guidance that allows plans to choose. A plan may continue to enforce a 6-month suspension that extends past January 1, 2019, but is not required to do so and could end the suspension period on January 1, 2019. If a plan decides to end the suspension early, it should provide notice to the participants who are affected. The notice should advise participants if their deferrals will be automatically reinstated or if the participant must complete a new deferral election.

Expanded Sources

The proposed regulations implement the Budget Act’s expansion of the set of contribution sources available for hardship distributions. But the preamble also states that plans may continue to limit the contribution sources available for hardship distributions, including earnings on those distributions.

As a result, plans need not make all possible contribution sources available for distribution and may restrict the sources available under a plan to a subset of all permissible contribution sources. The preamble also clarifies that safe harbor matching or nonelective contributions made under Code Section 401(k)(13) may be made available for hardship distributions because these contributions are subject to the same distribution limitations applicable to qualified nonelective contributions (QNECs) and qualified matching contributions (QMACs).

403(b) Plans

The hardship distribution rules for 403(b) plans are generally the same for 401(k) plans. However, the preamble points out that Code Section 403(b)(11) was not amended by the Budget Act to allow for hardship distribution of income attributable to section 403(b) elective deferrals.

As a result, earnings on 403(b) elective deferrals continue to be ineligible for distribution on account of hardship. In addition, the IRS points out that QNECs and QMACs in a Section 403(b) plan that are held in a custodial account continue to be ineligible for distribution on account of hardship, but QNECs and QMACs in a Section 403(b) plan that are not in a custodial account may be distributed on account of hardship.

The current hardship distribution safe harbors allow a participant to take a hardship if his or her dependent incurs a qualifying medical, educational, or funeral expense. The proposed regulations would add the participant’s primary beneficiary under the plan as an individual for whom qualifying medical, educational, and funeral expenses may be incurred as well.

This provision has been permitted since the Pension Protection Act (PPA) was enacted in 2006, in accordance with Section III of Notice 2007-07, but had not been included previously in the text of the hardship regulations.

Casualty Loss Safe Harbor Restored

The proposed regulations also modify the hardship safe harbor related to damage to a principal residence that would qualify for a casualty deduction. The rule would be amended to restore this safe harbor to its pre-TCJA scope by stating that the TCJA provision limiting deductibility to presidentially declared disasters does not apply in this context.

Additionally, the IRS has provided that plans may be amended to conform to the practice of the plan, including retroactively to January 1, 2018, if the plan provided hardship distributions for non-presidentially declared casualty related losses in 2018 (see discussion below concerning plan amendment dates).

Natural Disaster Safe Harbor

The proposed regulations would add a seventh type of expense to the existing list of six safe harbors deemed to be hardships. The new safe harbor would allow hardship withdrawals for expenses incurred as a result of certain natural disasters in an area designated by the Federal Emergency Management Agency (FEMA) for individual assistance.

The preamble provides that the intent is “to eliminate any delay or uncertainty concerning access to plan funds following a disaster.” Plans may allow for the new safe harbor effective any time after January 1, 2018, if a plan is properly amended (see discussion below concerning plan amendment dates).

Plan Amendments

The IRS expects that plan sponsors will need to amend their plan’s hardship provisions if the proposed regulations become final. The IRS is requesting comments on the proposed regulations by January 14, 2019. As a result, the earliest plan amendment deadline to conform to the required provisions of final regulations would be December 31, 2020, for calendar-year plans. But because the revised hardship distribution regulations are provided in proposed form, there is no current required deadline to amend plans for those provisions.

The preamble states that when the regulations become final, “all amendments that relate to the final regulations will have the same amendment deadline.” However, some plan sponsors may need or desire to amend their plans earlier.

Also, Rev. Proc. 2016-37 provides that for discretionary amendments to individually designed, non-governmental plans, “the plan amendment deadline is the end of the plan year in which the plan amendment is operationally put into effect. An amendment is operationally put into effect when the plan is administered in a manner consistent with the intended plan amendment (rather than existing plan terms).”

Accordingly, to the extent a plan puts into effect any optional provision of the proposed regulations in 2019, the plan may need to be amended by December 31, 2019 (for calendar-year plans) to reflect that provision.

Todd B. Castleton
Todd B. Castleton is counsel with Kilpatrick Townsend & Stockton’s Employee Benefits Practice in the firm’s Washington, D.C., office, where he leads the Qualified Retirement Plans team. He is a contributing editor of The 401(k) Plan Handbook, and formerly was contributing editor of the Guide to Assigning & Loaning Benefit Plan Money.