IRS Issues Final Regulations on Hardship Distribution Rules

Practical Law Legal Update w-022-1273 (Approx. 7 pages)

IRS Issues Final Regulations on Hardship Distribution Rules

by Practical Law Employee Benefits & Executive Compensation

Previous Hardship Distribution Rules

Under the previous regulations, a hardship distribution could be made to a plan participant if the distribution was:

Because of an immediate and heavy financial need. The Code requires the plan to set out objective and nondiscriminatory standards to determine the existence of an immediate and heavy financial need. Determining this need depends on the facts and circumstances as determined by the plan sponsor.
Limited to the amount necessary to satisfy that financial need.

Under a safe harbor (26 C.F.R. § 1.401(k)-1(d)(3)(iv)(E)), a participant was automatically considered to have an immediate and heavy financial need for certain specified expenses in the Code.

On February 9, 2018, the Bipartisan Budget Act of 2018 (Pub. L. No. 115-123) was signed into law (see Legal Update, Latest Government Funding Legislation Impacts Retirement Plans and Includes Health Provisions). The Act includes provisions that, among other things, modify the hardship distribution rules.

On November 9, 2018, the agencies issued proposed hardship distribution regulations (see Legal Update, IRS Issues Proposed Regulations on Hardship Distribution Rules). The final regulations are mostly similar to the proposed regulations, but they do take into account some of the public comments that were made on the proposed regulations.

Final Regulations

The final regulations amend the regulations governing hardship distributions from 401(k) plans to reflect statutory changes, including provisions concerning:

The participant's immediate and heavy financial need.
Whether the distribution is necessary to satisfy the financial need.
The amounts includible in hardship distributions.

Immediate and Heavy Financial Need

The final regulations amend the safe harbor under which a participant is deemed to have an immediate and heavy financial need if the hardship distribution is for certain specified expenses (26 C.F.R. § 1.401(k)-1(d)(3)(iii)(B); see Hardship Distributions for 401(k) Plans Checklist: Safe Harbor (Immediate and Heavy Financial Need)). The final regulations:

Reflect changes made by the PPA and add the participant's primary beneficiary as an individual for whom qualifying medical, tuition, and funeral expenses could be incurred.
Modify the provision (26 C.F.R. § 1.401(k)-1(d)(3)(iii)(B)(6)) concerning expenses that qualify for the casualty deduction under Code Section 165 (26 U.S.C. § 165) to specify that the deduction limitations added by the TCJA do not apply (26 U.S.C. § 165(h)(5)).
Add a new expense to the list of specified expenses, namely expenses and losses incurred because of a federally declared disaster, provided the participant's principal residence or place of employment at the time of the disaster was located in the designated disaster area. Unlike the agencies' disaster-relief announcements, the final regulations do not:
- include disaster-related expenses and losses of the employee's relatives and dependents;
- provide a specific deadline by which a request for a disaster-related hardship distribution must be made and do not provide a specific authority to relax certain procedural requirements under the plan; or
- provide an extended deadline for plan sponsors to add disaster-related distribution or loan provisions to the plan (which means that plans that are not amended to include hardship distribution provisions until a disaster occurs will have to adopt the amendment by the end of the plan year the amendment is first effective).

According to the preamble to the final regulations, the agencies do not expect that more disaster relief announcements will be needed for plans because the final regulations treat disaster-related expenses as safe harbor expenses. However, the agencies are considering additional guidance to address delayed amendment deadlines for safe harbor provisions that are added to a plan at a later date in response to a particular disaster.

Distribution Necessary to Satisfy the Financial Need

The final regulations:

Eliminate the regulatory safe harbor under which a distribution is deemed necessary to satisfy an immediate and heavy financial need if:
- the participant is prohibited from making contributions for a six-month period following the distribution; and
- the participant takes an available loan under the plan before taking a hardship withdrawal.
(26 C.F.R. § 1.401(k)-1(d)(3)(iv)(E).)
Replace the "facts and circumstances" standard for determining necessity with a general standard (26 C.F.R. § 1.401(k)-1(d)(3)(iv)(B)). Under the general standard:
- a hardship distribution may not exceed the amount of the participant's need;
- the participant must have obtained other available distributions under the plan; and
- the participant must represent that he has insufficient cash or other liquid assets to meet the need.

The final regulations do not permit plans to provide for a suspension of elective contributions or employee contributions as a condition of obtaining a hardship distribution.

The preamble to the final regulations explains that the final regulations provide more details than the proposed regulations regarding the participant representations regarding insufficient cash or other assets. The final regulations require the employee-participant to represent only whether the employee has cash or other liquid assets that are "reasonably available" to satisfy the immediate and heavy financial need and not earmarked for other short-term financial needs such as rent payments.

The final regulations also provide that an employee-participant's verbal representation of insufficient liquid assets may be made through a recorded telephone message.

The agencies state in the preamble, in response to a comment on the proposed regulations, that completing a plan' application process and providing required documentation are permissible conditions that may be imposed on a hardship distribution (in addition to the conditions currently included in Treasury Regulation Section 1.401(k)-1(d)(3)(iv)(B) and (C)).

Unlike the proposed regulations, the final regulations specify that the prohibition on suspensions applies only to:

Tax-qualified plans.
Code Section 403(b) plans.
Code Section 457(b) plans (26 U.S.C. § 457(b)).

This means that plans subject to Code Section 409A (26 U.S.C. § 409A) may retain their suspension provisions.

The preamble also clarifies that under the final regulations a suspension of employee contributions is not permitted starting on January 1, 2020, if matched employee contributions are distributed in conjunction with a hardship distribution of elective contributions.

For more information on the safe harbor, see Hardship Distributions for 401(k) Plans Checklist: Safe Harbor (Amount Necessary to Satisfy the Financial Need).

Code Section 403(b) Plans

The new rules relating to hardship distributions of elective contributions from a 401(k) plan generally apply to 403(b) plans. However, unlike the new rules for 401(k) plans:

Income attributable to Code Section 403(b) elective deferrals continues to be ineligible for hardship distributions.
QNECs and QMACs in a 403(b) plan that are in a custodial account continue to be ineligible for hardship distributions.

Applicability Dates and Plan Amendments

Generally, the final regulations apply to distributions made in plan years beginning after December 31, 2018, except that:

Treasury Regulation Section 1.401(k)-1(d)(3) (which provides rules for hardship distributions) applies to distributions made on or after January 1, 2020 (under the proposed regulations, it applied to distributions made in plan years beginning after December 31, 2018). Section 1.401(k)-1(d)(3) may be applied to distributions made in plan years beginning after December 31, 2018, and the prohibition on suspending an employee's elective contributions and employee contributions as a condition of obtaining a hardship distribution may be applied as of the first day of the first plan year beginning after December 31, 2018, even if the distribution was made in the prior plan year.
The prohibition on the six-month suspension of contributions following a hardship distribution would apply to distributions made on or after January 1, 2020. Plan sponsors may choose to apply the prohibition beginning on the first day of the first plan year beginning after December 31, 2018, even if the distribution was made in the prior plan year.
The requirement that plan sponsors obtain the participant's representation regarding insufficient cash or liquid assets to meet a financial need would apply to distributions made on or after January 1, 2020.
The changes to the list of safe harbor expenses would apply to distributions made on or after January 1, 2018.

401(k) plans' hardship distribution provisions must be amended to comply with the final regulations, and the amendments must be effective for distributions beginning no later than January 1, 2020. The preamble to the final regulations explains that a plan provision that does not result in a plan qualification failure, but is "integrally related" to a qualification requirement that has been changed so as to require the plan to be amended, may be amended by the same deadline that applies to the required amendment. A plan amendment reflecting the extension of the relief under Announcement 2017-15, to victims of Hurricanes Florence and Michael that was provided in the preamble to the proposed regulations, will be treated as amending a provision that is integrally related to a qualification requirement that has been changed.

Practical Implications

401(k) plan sponsors and practitioners should familiarize themselves with the final regulations governing hardship distributions from 401(k) plans and be mindful of the various applicability dates of the regulations.

IRS Issues Final Regulations on Hardship Distribution Rules | Practical Law