Hardship Withdrawals: Trust but Verify

At the end of February, the IRS issued a memorandum for Employee Plans Examinations Employees which provided guidelines for hardship distributions from 401(k) plans. The process for determining whether a 401(k) hardship distribution request is “deemed to be on account of an immediate and heavy financial need” isn’t plain and simple. By issuing the memorandum, the IRS aims to make the process clearer by instructing personnel to follow a two-step process.

Before we get to this two-step process, let’s first recall when a distribution can be justified for an immediate and heavy financial need.

1. Expenses for medical care deductible under section 213(d) for the employee or the employee’s spouse, children or dependents or primary beneficiary under the plan;

2. Costs directly related to the purchase of a principal residence;

3. Payment of tuition, related educational fees, room and board expenses for up to the next 12 months of post-secondary education for the employee or the employee’s spouse, children or dependents or primary beneficiary under the plan;

4. Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence;

5. Payments for burial or funeral expenses for the employee’s deceased parents, spouse, children or dependents or primary beneficiary under the plan; or

6. Expenses for the repair of damages to the employee’s principal residence that would qualify for the casualty deduction under section 165.

So if a plan participant requests a distribution for one of the above reasons, he or she may lawfully, without any penalties, prematurely withdraw funds from their 401(k) account. However, it is your responsibility as a plan sponsor to examine the request, determine whether the distribution is deemed immediate and financially necessary, and substantiate it. This is where the IRS guidance comes in handy.

During the examination, the IRS provides the following two-step process:

Step 1

• Determine whether the employer or third-party administrator, prior to making a distribution, obtains: (a) source documents (such as estimates, contracts, bills and statements from third parties); or (b) a summary (in paper, electronic format, or telephone records) of the information contained in source documents.

• If a summary of information on source documents is used, determine whether the employer or third-party administrator provides the employee notifications required on Attachment I prior to making a hardship distribution.

Step 2

• If the employer or third-party administrator obtains source documents under Step 1(i)(a), review the documents to determine if they substantiate the hardship distribution.

• If the employer or third-party administrator obtains a summary of information on source documents under Step 1(i)(b), review the summary to determine whether it contains the relevant items listed on Attachment I.

• If the notification provided to employees in Step 1(ii) or the information reviewed in Step 2(ii) is incomplete or inconsistent on its face, you may ask for source documents from the employer or third-party administrator to substantiate that a hardship distribution is deemed to be on account of an immediate and heavy financial need.

• If the summary of information reviewed in Step 2(ii) is complete and consistent but you find employees who have received more than 2 hardship distributions in a plan year, then, in the absence of an adequate explanation for the multiple distributions and with managerial approval, you may ask for source documents from the employer or third-party administrator to substantiate the distributions. Examples of an adequate explanation include follow-up medical or funeral expenses or tuition on a quarterly school calendar.

• If a third-party administrator obtains a summary of information contained in source documents under Step 1(i)(b), determine whether the third-party administrator provides a report or other access to data to the employer, at least annually, describing the hardship distributions made during the plan year.

By following the outlined steps and making sure that all criteria is satisfied, plan sponsors will be “treated as satisfying the substation requirement for making hardship distributions deemed on the account of an immediate and heavy financial need.”

When it comes to hardship distributions, it is important to know that it is the sole responsibility of plan sponsors to track hardship withdrawals. In “It’s Up to Plan Sponsors to Track Loans, Hardship Distributions” article by the IRS, they remind you to keep all documents and records for hardship withdrawals. They also point out that, “electronic self-certification is not sufficient documentation of the nature of a participant’s hardship.”

There is nothing wrong with self-certification as a means of showing that a distribution from a 401(k) plan was the only way to lessen a hardship. Although, the IRS is significantly concerned with allowing participants to maintain the records relating to a hardship, as these records are not always accessible by the IRS during an audit.

To avoid any future issues that may arise during an IRS audit, make sure to obtain and keep all hardship distribution records in paper or electronic format.

Finally, in its “Hardship Distribution Tips from EP Exam” article, the IRS reminds plan sponsors to check plan documents and make sure they allow for hardship distributions. Even if the law permits hardship distributions, it is not uncommon for plan sponsors to be in violation of distribution rules by granting them if the plan documents don’t permit them. This is one of the rare cases where plan documents supersede the law.

Make sure to double check that your plan documents permit hardship distributions, and know the exact reasons for when these distributions are allowed. For example, if a plan permits distributions for funeral expenses, but prohibits distributions for costs directly related to the purchase of a principal residence, a plan can’t distribute funds towards a down payment even though the law allows it.

As you can see, hardship withdrawals have been on the IRS’s agenda recently, meaning that the IRS sees errors that plan sponsors make with these distributions. Luckily the IRS has provided plan sponsors with explicit instructions and guidance on how to handle hardship distributions correctly. To summarize:

• Check that the plan documents permit hardship distributions and when they are allowed

• Make sure to examine the request, determine whether the distribution is for an immediate and financial need, and substantiate it

• Track and document all hardship withdrawals

By following the above steps, the chances of seeing your plan in violation of hardship distribution rules will be low.