On November 9, 2018, the Internal Revenue Service (“IRS”) released a Notice of Proposed Rulemaking (proposed regulations) that, if finalized in present form, would significantly modify and relax some of the rules that govern hardship distributions (also known as hardship withdrawals) from 401(k) plans. The changes generally reflect relevant provisions included in the Bipartisan Budget Act of 2018 (“BBA”) and other recent legislation. Among the more significant changes are the elimination of the six-month suspension of deferrals requirement, and elimination of the prior requirement that participants take a plan loan prior to taking a hardship distribution. However, there are other important changes as well. Some highlights of the changes included in the proposed regulations are identified below.
No More Six-Month Suspension of Elective Deferrals. Under current regulations, participants who receive a hardship distribution from a 401(k) plan generally are prohibited from making elective deferral contributions to the plan for six months following receipt of the distribution. BBA directed the Secretary of the Treasury to delete the six-month prohibition. The proposed regulations reflect this Congressional directive, which is now the law.
No More Need to Take Plan Loans. Similarly, BBA amended the Internal Revenue Code (“Code”) to provide that a hardship distribution is not treated as failing to be made upon the hardship of an employee solely because the employee does not first take any available loan under the plan. The proposed regulations reflect this change also. Note that a 401(k) plan may still choose to require participants to first take plan loans.
Expanded Sources of Contributions Available for Hardship Withdrawals. BBA also amended the Code to provide that a plan may choose to permit hardship distributions from 401(k) plans of: (1) elective contributions; (2) qualified nonelective contributions (“QNECs”); and (3) qualified matching contributions (“QMACs”), along with earnings on these amounts, regardless of when they were contributed or earned. However, a plan may choose to limit the source of contributions available for hardship distributions (for example, by excluding distributions of QNECs).
Expanded List of Safe-Harbor Expenses Deemed to Constitute Hardship. The proposed regulations would also modify the “safe harbor” list of expenses for which hardship withdrawals are deemed to be made on account of an “immediate and heavy financial need” by:
- Adding the term “primary beneficiary under the plan,” defined as an individual for whom qualifying medical, educational, and funeral expenses may be incurred (this would permit plans to permit hardship distributions for certain medical, tuition, and funeral expenses incurred on behalf of a primary beneficiary);
- Clarifying that damage to a principal residence that would qualify for a casualty deduction under Code Section 165 does not necessarily have to be in a Federally declared disaster area (see “Tax Reform May Have Had Unintended Effect on Hardship Withdrawals Under 401(k) Plans” for background information).
- Adding a new type of expense to the list, relating to expenses incurred as a result of certain Federally declared disasters, as long as the participant’s home or principal place of business at the time of the disaster was located in an area designated for Federal assistance.
Revised Determination of Distribution Necessary to Satisfy Financial Need. The proposed regulations would eliminate the rule under which the determination of whether a distribution is necessary to satisfy a financial need is “based on all the relevant facts and circumstances,” substituting the nebulous condition with one general standard for determining whether a distribution is necessary.
Under the revised standard: (1) a hardship distribution may not exceed the amount of an employee’s need (including any amounts necessary to pay any Federal, state, or local income taxes or penalties); (2) the employee must have obtained other available distributions under the employer’s plans (other than loans – see above); and (3) the employee must represent that he or she has insufficient cash or other liquid assets to satisfy the financial need. A plan administrator may rely on such a representation unless the administrator has actual knowledge to the contrary. Plans may establish certain additional criteria as well (including a loan requirement – see above).
Plan administrators will welcome this change, as it should eliminate a lot of the previous uncertainty in making determinations of hardship.
Effective Dates. The changes made by the proposed regulations would generally be effective as of January 1, 2019. However, in certain cases, the elimination of the six-month suspension requirement may be applied earlier, even if the distribution was made in the prior plan year. There are some other rather awkward effective dates that apply to particular situations – please confer with your ERISA counsel or consultant for details.
Plan Amendments Required. 401(k) plans that permit hardship distributions will need to be amended to reflect the changes. Generally, the deadline for amending plans to reflect a change in qualification requirements is the end of the second calendar year that begins after the IRS issues its annual “required amendments list” that includes the change. So, assuming the regulations are finalized, and the required amendments list issued in 2019 includes the changes contained in the final regulations, a 401(k) plan that permits hardship distributions would have to be amended by no later than December 31, 2021. As a “best practice,” plan sponsors should consider making plan amendments in advance of the “drop-dead” date.