On September 23, 2019, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) published final regulations that modify the hardship distribution rules for profit sharing, 401(k), 403(b), and eligible governmental 457(b) plans. The final hardship distribution regulations generally expand and streamline the use of hardship distributions for changes made in legislative acts spanning more than a decade: the Pension Protection Act of 2006, the Heroes Earnings Assistance and Relief Tax Act of 2008, the Tax Cuts and Jobs Act of 2017, and the Bipartisan Budget Act of 2018.
The previous 401(k) hardship distribution regulations allowed a distribution subject to these criteria:
- The participant must have an immediate and heavy financial need.
- The plan must set reasonable and objective standards for determining the existence of an immediate and heavy financial need.
- The hardship distribution must be limited to the amount and necessary to satisfy the immediate and heavy financial need.
In determining the existence of an immediate and heavy financial need and whether a hardship distribution is necessary to satisfy that need, the plan can set standards under facts and circumstances sufficient to establish the need and necessity of a hardship distribution or the plan can follow safe harbor provisions in the regulations that deem certain events meet that need and necessity.
What the Final Regulations Change
Safe Harbor Hardship Distributions
The final regulations expand the safe harbor conditions to determine the existence of an immediate and heavy financial need and whether a hardship distribution is necessary to satisfy such need.
Deemed Immediate and Heavy Financial Need
The final regulations amend the safe harbor requirements that describe when a participant has an immediate and heavy financial need in these ways:
- A participant’s primary beneficiary qualifies as an individual for whom qualifying medical, tuition, and funeral expenses could be incurred.
- The deduction limitations added by the Tax Cuts and Jobs Act for the casualty deduction on a participant’s principal residence under Section 165 of the Internal Revenue Code do not apply.
- Expenses and losses incurred because of a federally declared disaster are now a deemed immediate and heavy financial need, provided that the participant’s principal residence or place of employment in the designated disaster area when the disaster occurred.
The IRS updated its Internal Revenue Manual steps for examining general hardship distributions in light of the final regulations. The Internal Revenue Manual update included hardship notifications the employer must provide to the employee, general information for all hardship requests, and the specific information participants must provide for deemed hardship requests. Participants requesting hardship distributions may provide a summary representation of a hardship in most instances. The IRS lists specific questions participants must answer to provide a summary representation of their hardship needs. The questions vary depending on the hardship need the participant claims occurred.
Deemed Necessity of Hardship Distribution to Satisfy Financial Need
The prior safe harbor necessity requirements mandated a six-month suspension of employee deferrals for all arrangements maintained by the employer after taking a hardship distribution, complete exhaustion of participant loans and other distributions permitted under the plan, and that the participant could not satisfy the immediate and heavy financial need through assets outside the plan.
The final regulations prohibit plans from applying the six-month suspension of employee deferrals or contributions for participants that take a hardship distribution. The prohibition on suspension applies to tax-qualified plans, 403(b) plans, and eligible governmental 457(b) plans. Nonqualified deferred compensation arrangements under Section of 409A of Code may retain such suspension provision without complications or may be amended, subject to the requirements of Section 409A, to remove such suspension.
The final regulations no longer require a participant to take available participant loans before taking a hardship distribution. This is an optional change, unlike the prohibition on suspension. Note that participants must still take all other distributions available under the plan and must not be able to satisfy the immediate and heavy financial need with assets outside the plan. The final regulations preserve and set an employer’s ability to rely on a participant’s representation that he or she does not have assets outside the plan to satisfy the immediate and heavy financial need rather than require an employer to investigate its employees’ finances to make that determination.
Facts and Circumstances Necessitate Hardship Distribution
The final regulations also replace the facts and circumstances test for determining if a hardship distribution is necessary to satisfy the financial needs of a participant with a general standard that requires:
- the hardship distribution not exceed the participant’s need;
- the participant first obtain other distributions under the plan; and
- the participant represent that he or she does not have sufficient cash or other liquid assets reasonably available to meet the need and the plan administrator has no actual knowledge to the contrary.
The final regulations bring the facts and circumstances test much closer to the safe harbor provisions for determining whether a hardship distribution is necessary to satisfy a participant’s immediate and heavy financial need.
Expanded Sources for Hardship Distributions
Prior requirements ignored a participant’s employee deferral earnings, qualified nonelective contributions (QNECs), qualified matching contributions (QMACs), and safe harbor employer contributions in establishing the maximum amount permitted as a hardship distribution. Hardship distributions were effectively limited to employee deferrals and vested non-safe harbor employer contributions. The final regulations now include employee deferral earnings, QNECs, QMACs, and safe harbor employer contributions in the maximum amount permitted as hardship distributions in a 401(k) plan.
Due to a missing element in the legislative language expanding the sources for hardship distributions, none of the above expanded sources apply to custodial 403(b) plans, and the employee deferral earnings expansion does not apply to any 403(b) plan, including those funded by annuities or retirement accounts.
Effect on Plan Sponsors
Plan sponsors should consider reviewing their plans’ hardship distribution provisions and amending them to reflect the final regulations. The final hardship regulations are effective in the plan year starting after December 31, 2018, except:
- the final regulation on prohibiting suspension of an employee’s deferral contributions because of hardship distribution goes into effect January 1, 2020, but plans may apply the regulation to contributions following hardship distributions in plan years beginning after December 31, 2018;
- the final regulation on the facts and circumstances necessitating distributions—which requires participants to represent that they do not have sufficient cash or other liquid assets to meet their needs—applies to distributions made after January 1, 2020; and
- including federally declared disasters as a safe harbor hardship distribution is permitted for hardship distributions made on or after January 1, 2018.
Kevin L. Burch is of counsel in the Indianapolis office of Ogletree Deakins.
Matthew J. Hoffman is a 2018 graduate of the J. Reuben Clark Law School at Brigham Young University and a 2019 LL.M. graduate of the University of Florida Levin College of Law. He is currently awaiting admission to the state bar of Indiana.