This month, the Internal Revenue Service (“IRS”) issued eagerly-awaited proposed regulations regarding hardship distributions for 401(k) and 403(b) plans. The recent passage of the Bipartisan Budget Act of 2017 (“BBA”) and the Tax Cuts & Jobs Act of 2018 (“Tax Act”) resulted in inconsistencies with some of the current distribution rules, which in turn caused confusion for plan sponsors, administrators, and employers. The proposed regulations incorporate changes made under the BBA and Tax Act and offer guidance on the new rules. It appears that the proposed regulations (although not yet finalized) may be generally applied for plan years beginning on or after January 1, 2019, unless a specific exception applies, each of which is discussed below.
While the IRS did not expressly provide that plan sponsors and administrators could rely on the proposed regulations as is for plan years beginning on or after January 1, 2019, it is anticipated that the final regulations will be issued during 2019 with potentially no-to-minimal changes. Based on a fair reading of the proposed regulations, some of which have fast-approaching effective dates, practitioners and experts in the field have taken the position that plan sponsors and administrators can begin to administratively implement some of the optional and mandatory changes as proposed for plan years beginning on or after January 1, 2019, and amend their plans accordingly with the understanding that additional changes and amendments may be needed after the final regulations are issued.
Currently, 401(k) and 403(b) plans that offer hardship withdrawals allow participants to receive a distribution of their elective deferrals when they have “an immediate and heavy financial need” and the amount of the withdrawal is limited to an amount “necessary” to meet that need based on “all relevant facts and circumstances.” The current rules provide specific safe harbor circumstances that qualify as an “immediate and heavy financial need” and outline how participants can substantiate that the amount of the withdrawal is “necessary” to meet those needs.
The proposed regulations modify these rules by relaxing some of the requirements and providing needed clarity regarding others. Generally, the proposed regulations modify the list of safe harbor circumstances that constitute “an immediate and heavy financial need;” create a new standard for determining whether a distribution is “necessary” to satisfy the participant’s financial need; and expand the types of contributions and earnings that may be distributed for financial hardship.
- Clarification and Expansion on Safe Harbor Circumstances Amounting to “Immediate and Heavy Financial Need.” As noted above, the current rules set out specific safe harbor circumstances that constitute an “immediate and heavy financial need” allowing for hardship distributions. The proposed regulations modify some of these circumstances as follows:
- Casualty Loss. Current rules allow participants to seek a hardship distribution for a “casualty loss” to a participant’s principal residence that would otherwise be deductible. However, the Tax Act eliminated a deduction for casualty losses unless the loss was due to a federally-declared disaster. The proposed regulation clarifies that the Tax Act change does not apply to casualty loss hardship distributions under 401(k) and 403(b) plans and confirms that participants are permitted to seek a hardship distribution regarding damages to their principal residence regardless of whether those losses are the result of a federally-declared disaster.
- Federally-Declared Disaster Event. In light of the Tax Act and the current rules, which do not expressly permit hardship distributions for losses and expenses related to federally-declared disasters, the IRS has proposed a category of permissible safe harbor hardship distributions to account for these losses. The proposed regulations permit hardship distributions for losses resulting from federally-declared disasters, provided that the employee’s principal residence or place of employment at the time of the disaster was located in an area designated by FEMA for individual assistance.
- Qualifying Medical, Educational, and Funeral Expenses Incurred by Participant’s “Primary Beneficiary.” Current rules allow for distributions for a participant’s qualifying medical, educational, and funeral expenses. This rule has been modified to incorporate a change made by the Pension Protection Act of 2006 regarding inclusion of a primary beneficiary. The proposed change confirms that a participant’s primary beneficiary’s qualifying expenses also can serve as a safe harbor circumstance allowing a hardship distribution.
These proposed changes to the safe harbor rules may be retroactively applied to hardship distributions made on or after a date as early as January 1, 2018.
- Elimination of “Facts and Circumstances” Test to Determine Necessary Financial Need. The proposed regulations eliminate the test to determine whether a distribution is necessary to satisfy financial need based on all “facts and circumstances” and replaces it with the following three-part inquiry that is more objective:(1) the hardship distribution may not exceed the amount of the participant’s need; (2) the participant must have obtained other available distributions under the employer’s plans; and (3) the participant must represent (in writing or other acceptable forms) that he or she has insufficient cash or liquid assets to satisfy the financial need.
This proposed regulation allows (but does not require) plan sponsors and administrators to implement this standard for plan years beginning after December 31, 2018. The change will become mandatory for hardship distributions made on or after January 1, 2020, if the proposed regulations are finalized.
- Elimination of the Six-Month Suspension. In addition to the “facts and circumstances” test, the current IRS regulations allow for participants to substantiate their necessary financial need for a hardship distribution by following a set of safe harbor rules. One of the safe harbor rules prohibits participants who take a hardship distribution from making future contributions to the plan or other employer-sponsored plans for six months. The proposed regulations eliminate the suspension requirement. This was done to allow participants the opportunity to replenish their accounts as soon as possible.
- This proposed regulation allows plan sponsors to either eliminate or maintain the suspension for plan years beginning after December 31, 2018, even if the distribution was taken during the prior plan year. However, the elimination of the six-month suspension requirement will become mandatory for all hardship distributions made on or after January 1, 2020, if the proposed regulations are finalized.
- Elimination of the Requirement to Take Plan Loans First. The proposed regulations also allow for the elimination of the other safe harbor rule requiring a participant to take all available loans under the employer’s plans before taking any hardship distributions. However, unlike the elimination of the suspension period, this change will not be mandatory. This means that 401(k) and 403(b) plans can continue to require that participants take loans available under the plan before becoming eligible to take a hardship distribution.
- Plan sponsors and administrators may (but are not required to) eliminate this requirement for distributions made in plan years beginning after December 31, 2018.
- Expansion of Hardship Distribution Sources. For hardship distributions made in plan years beginning after December 31, 2018, the proposed regulations permit (but do not require) plans to allow hardship withdrawals from an expanded pool of sources, including earnings on elective deferrals; qualified non-elective contributions (QNEC); qualified matching contributions (QMACs); earnings on QNECS and QMACs; and safe harbor employer contributions and earnings thereon, regardless of when these sources were earned or contributed.
- Notably, with regard to 403(b) plans, earnings on elective deferrals and QNECs and QMACs in custodial accounts continue to be ineligible for hardship distributions.
- Plan sponsors should review their 401(k) and 403(b) plans to determine the extent that their hardship distribution provisions and procedures comply with the proposed regulations and update plan documents, including distribution procedures and summary plan descriptions, accordingly (with the understanding that the proposed regulations have not been finalized).
- While most of the proposed changes are optional, there are some mandatory changes that plans must implement by January 1, 2020 (assuming the proposed changes are finalized as is), including the elimination of the six-month suspension requirement and the implementation of the written certification requirement.
- Notably, because the proposed regulations are not yet finalized, the applicable deadline to amend plan documents to include these mandatory changes has not been established. However, plan sponsors and administrators should be prepared to implement the mandatory changes by the proposed deadline and amend their plan documents as necessary once the changes are finalized.
- If plan sponsors choose to adopt any of the optional changes, including for example, removing the loans-first requirement or expanding available hardship distribution sources, for plan years beginning after December 31, 2018, they will need to update their plan documents as necessary by the end of the plan year wherein the change was administratively implemented with the understanding that they might have to amend the plan again once the final regulations are issued.
- Plan sponsors and administrators should provide training to any individuals who process hardship distribution requests regarding the proposed regulations and any changes to plan procedures.
- When the final regulations are issued, these action steps should be revisited to ensure there is continued and consistent compliance.
For more information about anything discussed in this Client Alert, please contact a member of Maynard Cooper & Gale’s Employee Benefits & Executive Compensation Practice Group. This client alert was prepared by Beth Beaube, Jessica Everest, and Claire Martin.