Otis Redding and the Black Crowes may have proclaimed themselves “hard to handle now,” but thanks to recent guidance from the Internal Revenue Service (IRS), hardship distributions from 401(k) plans are a bit less hard to handle, now.
In late 2017, when Congress passed the Tax Cuts and Jobs Act of 2017 (TCJA), it made an inadvertent change that narrowed the opportunity for participants in employer-sponsored retirement plans to take hardship distributions resulting from casualty losses. In 2018, Congress passed the Bipartisan Budget Act of 2018 (BBA), which made significant changes to liberalize the process for taking hardship distributions. In just the last few days, the IRS introduced proposed regulations seeking to clarify some of these new provisions and to provide some additional guidance.
By way of background, the Internal Revenue Code of 1986, as amended, provides that participants in Section 401(k) and 403(b) plans may take distributions from the plans only in limited circumstances, such as upon incurring a hardship. The Treasury Regulations promulgated under Code Section 401(k) provide that a distribution is deemed to have been made on account of hardship if (1) it is made “on account of an immediate and heavy financial need” and (2) the amount of the distribution does not exceed the amount necessary to satisfy the need (plus any amount necessary to pay taxes, etc., on the distribution). The TCJA and BBA modified both portions of the “deemed” hardship safe harbor, which the proposed regulations clarified as follows:
Prior to the TCJA, one of the immediate and heavy financial needs set forth in the regulation was an expense to repair damage to an employee’s principal residence that would qualify as a casualty deduction under Code Section 165 (and most plans simply referenced Code Section 165). The TCJA revised Code Section 165 to provide that an individual could deduct home repair expenses as a casualty loss only when that loss was attributable to a federally declared disaster. Accordingly, following the TCJA, hardship distributions would have been limited to federally declared disaster zones (e.g., amounts necessary for repairs from a house fire would not constitute an immediate and heavy financial need, but amounts attributable to repair from a fire in a federal disaster zone would be). Fortunately, the proposed regulations revise the “immediate and heavy financial need” language specifically to remove the federal disaster requirement, so this provision will operate as it has historically.
Federal Disaster Zones
Presumably in an effort not to completely ignore the changes to casualty loss deductions established in the TCJA, the proposed regulations add a new safe harbor for an immediate and heavy financial need for expenses and losses (including a loss of income) incurred by an employee on account of a disaster declared by the Federal Emergency Management Agency (FEMA) as long as the employee’s principal residence or principal place of employment at the time of the disaster was in the location designated by FEMA.
Suspension of Contributions
Prior law required that in order for a distribution not to exceed the amount necessary to satisfy the financial need, a participant would have to suspend elective deferrals to the plan for six months following the distribution. The BBA removed this requirement for plan years beginning after December 31, 2018. Importantly, although some read the BBA’s removal of this six-month suspension as optional, the proposed regulations clarify that a plan may not provide for a suspension of elective deferrals for a distribution that is made on or after January 1, 2020.
In an interesting twist, the proposed regulations allow plan sponsors to elect to apply this new suspension rule as of the first day of the first plan year beginning after December 31, 2018. If a plan utilizes this rule, a participant who took a hardship distribution in the second half of 2018 (and therefore had his or her elective deferral contribution suspended) could begin contributing to the plan again on January 1, 2019 (assuming a calendar-year plan), even though the six-month suspension period had not expired.
Exhausting Other Distributions
Prior law also required that a participant exhaust all available sources before taking a hardship, including taking a loan from a plan. The BBA removed this requirement, making it easier for participants to take hardship distributions. In implementing this change, the proposed regulations—likely in an effort to ensure that participants do not abuse the removal of the loan requirement—add a new provision that requires a participant to represent (in writing, electronically, etc.) that he or she has insufficient cash or other liquid assets to satisfy the need, effective for distributions after January 1, 2020. Unlike the change to eliminating the suspension of contributions, the proposed regulations specifically allow a plan to include additional conditions for a hardship distribution, such as continuing to require that an employee obtain all nontaxable loans before taking a hardship distribution.
Sources Eligible for Hardship Distributions
Prior law prohibited hardship distributions from earnings on elective deferrals, qualified nonelective contributions, and qualified matching contributions. The BBA (and the proposed regulations) removes this limitation, allowing hardship distributions from all of these sources, and it further clarifies that employer-matching and profit-sharing contributions are also eligible sources for hardship distributions.
Individuals Eligible for Hardship Distributions
Prior law allowed a hardship distribution in the case of qualifying medical, educational, and funeral expenses for the employee or the employee’s spouse, children, or dependents. The proposed regulations expand these rules to allow for a hardship when the primary beneficiary under the plan (i.e., the individual with an unconditional right to all or a portion of the employee’s account balance upon the employee’s death) experiences a need relating to qualifying medical, educational, and/or funeral expenses.
The Treasury Regulations promulgated under Code Section 403(b) cross-reference the Code Section 401(k) regulations for hardship distributions, so the changes listed above also generally apply to Section 403(b) plans. However, there are differences in allowable sources between the Section 403(b) plans and Section 401(k) plans after taking into account the BBA. First, earnings on Section 403(b) elective deferrals are still prohibited as a hardship distribution source. Second, only qualified non-elective employer contributions (QNECs) and qualified matching contributions (QMACs) that are not in a custodial account may be hardship distribution sources. If the QNECs or QMACs are within a custodial account, participants still are prohibited from using such sources for a hardship distribution.
Amendment Deadline and Other Action Items
Now that the IRS has issued guidance on these changes, plan sponsors may want to consider whether they wish to revise their plans to reflect the proposed regulations, while keeping in mind the required change to the suspension of elective deferrals in 2020. The likely deadline for a Plan Sponsor to make plan amendments reflecting these changes is December 31, 2021. This is based on the rule that requires amendments to be made by the end of the second calendar year following the year in which the IRS lists the amendment on its Required Amendments List. Because the recently issued 2018 Required Amendments List did not include the hardship distribution changes, the deadline is pushed back to December 31, 2021. Plan sponsors who already have amended their plans to reflect the changes in the TCJA and BBA may want to review their amendments to ensure they address the proposed regulations’ requirements. Although we understand the desire to be proactive and address the proposed regulations now, it may be prudent to wait until 2019 to make any plan document changes, as the IRS, through the process of finalizing the regulations, may make changes to the proposed regulations (which would then require an additional plan amendment).