Potential Hardship Distribution Changes for 2019, 2020

by Robert Shipp, QKA

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Earlier this year, the Bipartisan Budget Act of 2018 (BBA) made several changes to retirement plans. Of all the changes brought by BBA, those made to 401(k) and 403(b) hardship distributions are among the most likely to affect your clients. As a result of BBA, the IRS recently released proposed hardship regulations. As of this writing, these regulations were not yet final, but do provide clues as to how the final regulations—due out early in 2019—might read.

BBA Changes

The BBA changes detailed here could affect hardship distributions taken as early as January 1, 2019, depending on the specific provision and the options allowed within that provision.

1.   BBA directs the Treasury Department to write new regulations eliminating the requirement that elective deferrals (either pretax or Roth) be suspended for six months after a hardship distribution is taken.

2.   BBA allows additional contribution types to be used for hardship distributions, including

  • qualified nonelective contributions (QNECs);

  • qualified matching contributions (QMACs);

  • earnings on these QNECs and QMACs;

  • certain safe harbor contributions; and

  • earnings on 401(k) deferrals.

NOTE: QNECs and QMACs may assist your retirement plan in satisfying certain nondiscrimination tests for deferrals and matching contributions, respectively.

3.  BBA eliminates the requirement that participants to take a plan loan before receiving a hardship distribution, effective for distributions taken after December 31, 2018.

Proposed Regulations Changes

In addition to the changes made by BBA, the proposed regulations as currently drafted make several changes and clarifications as detailed below.

1.   “FEMA-declared disaster” was added as a new distribution reason deemed to satisfy the “immediate and heavy financial need” requirement for hardship distributions. This reason is potentially available for distributions taken as early as January 1, 2018, if the plan document is timely amended.

2.   Under BBA, deductions for casualty losses taken under Internal Revenue Code Section (IRC Sec.) 165 are only allowed for a federally-declared disaster, starting January 1, 2019.  Historically, this deduction eligibility has been deemed to satisfy the “immediate and heavy financial need” requirement for hardship distributions. Despite future restrictions on claiming this deduction, the proposed regulations clarify that for hardship distribution purposes only, a casualty loss under IRC Sec. 165 need not be the result of a federally-declared disaster. For all other tax-related purposes, however, a federally-declared disaster is still required under IRC Sec. 165.

3.   Two of the three criteria for determining whether a hardship distribution is necessary to meet an “immediate and heavy financial need” were modified. Currently, 1) the hardship must not exceed the financial need, 2) the employee must take a loan or in-service distribution prior to a hardship, and 3) the employer may rely on the employee’s representation that the need cannot be satisfied by using other means outside of the plan (e.g., commercial loans, selling property, other available resources).

Proposed regulations change the second and third criteria so that taking a loan would not be required and the employer may rely on the employee’s representation that the need cannot be satisfied from outside of the plan using cash or other liquid assets. That is, all available resources outside the plan other than cash or liquid assets need not be considered. The employer is still required to substantiate the reason for the hardship (e.g., if an employee incurs medical expenses and requests a hardship, the medical bills should be reviewed by the plan sponsor to verify the need.)

Should the proposed regulations be finalized in their current form, plan sponsors would still have the option to require that loans be taken first or that illiquid assets or other resources outside of the plan be considered before granting a hardship. The proposed regulations simply remove them as requirements.

4.   Earnings on 403(b) deferrals would not be available for hardship, whether from custodial accounts or annuity contracts.

5.   QNECs and QMACs may be taken from annuity-based 403(b) arrangements, but not 403(b) custodial accounts.

6.   Deferral suspensions incurred as a result of a hardship distribution taken before January 1, 2020, may be allowed to continue for the entire six months, or may be cut off at another date at the plan sponsor’s discretion. But for hardship distributions taken on or after January 1, 2020, a suspension of any kind cannot be imposed.

In the Meantime…

While the IRS reviews public comments on the proposed regulations, you may want to start considering what this may mean for your clients from a plan design perspective.

  • If a plan does not already allow for hardship distributions, the plan sponsor might now consider allowing them, given the new flexibility.

  • A plan sponsor with an already lenient plan document in terms of hardship distributions might consider making the document more lenient to be more in line with the changes.

  • A plan sponsor may need to decide whether to use the new, more lenient rules or to continue operating under the existing rules (with the exception of mandating deferral suspensions after January 1, 2020).

Regardless, once the IRS provides final guidance, you may want to work with your document sponsor and other third-party administrators to make amendments as your plan design preferences dictate. The important thing is to be aware of how the changes may affect your clients and their plans so that you’re prepared when the time comes to implement the changes.