Hardship Distributions Made Easier
On September 19, 2019, the IRS issued final regulations that make retirement plan assets more accessible to those experiencing financial hardship. Released approximately 10 months after the proposed regulations, the final hardship distribution regulations address changes made by the Bipartisan Budget Act of 2018 (BBA) and satisfy a BBA provision directing the IRS to update its hardship regulations in general.
Among other things, the final hardship distribution regulations allow employers to broaden the employee contribution sources (including earnings) available for hardship distributions, and to grant a hardship distribution without first requiring the participant to take a plan loan. In addition, the regulations eliminate the six-month suspension of salary deferral and employee after-tax contributions (employee contributions) following receipt of a hardship distribution.
Hardship Distribution Overview
Retirement plan participants generally are prohibited from taking plan distributions unless certain events occur—such as separation from service or attainment of age 59½. But employers are permitted to design plans to allow participants experiencing financial difficulties to take hardship distributions.
Before receiving a hardship distribution, a participant must meet two conditions. First, the participant must have an “immediate and heavy financial need.” Second, the distribution must be necessary to satisfy that financial need.
The final regulations do not change how employers determine whether participants have an immediate and heavy financial need. Employers may still generally choose to use safe harbor rules (some of which changed under the final regulations) or may rely on “facts and circumstances.”
The final regulations do change how employers determine if a distribution is necessary to satisfy the financial need. Instead of relying on facts and circumstances, employers must now follow a general standard when determining if a participant has met this requirement.
The IRS adopted the final regulations with minimal changes from the proposed regulations. The highlights of the final regulations are discussed next.
“Immediate and Heavy Financial Need” Safe Harbor Provisions
The final regulations make the following changes to the “immediate and heavy financial need” safe harbor provisions.
Federal disaster declarations
The final regulations add a safe harbor for “expenses and losses—including loss of income—incurred by the employee” in FEMA-declared disasters. Employers may apply this safe harbor to distributions taken on or after January 1, 2018. According to the IRS, this safe harbor expense differs from its previous disaster relief in three ways.
The safe harbor applies only to the participant’s losses and expenses (not to the losses and expenses of the participant’s relatives or dependents.)
Participants do not have a specific deadline by which to take a hardship distribution. And although the IRS does not have the authority to relax certain procedural requirements, employers may be more flexible when processing hardship distributions following a disaster.
An employer that chooses to wait until a disaster occurs to allow disaster-related distributions must amend its plan by the end of the plan year in which the amendment first applies.
This safe harbor is meant to end any uncertainty about accessing plan assets following a major disaster. As a result, the IRS and Treasury Department do not believe that future disaster-related announcements will be needed.
Repairing damage to principal residence
The Tax Cuts and Jobs Act of 2017 (TCJA) eliminated an income tax deduction for certain personal casualty losses for tax years 2018 through 2025 unless the losses were part of a federally-declared disaster. As a result, the availability of the safe harbor for repairing damage to a principal residence was severely limited. The final regulations remove the limitation imposed by TCJA for hardship distribution purposes, restoring the broad usefulness of this safe harbor.
Primary beneficiary safe harbor
This change aligns the regulations with an earlier law change that—plan permitting—includes the hardship of an employee’s primary beneficiary for medical, educational, or funeral expenses.
Determining Whether a Distribution is Necessary to Satisfy a Financial Need
The final regulations create a general standard for determining whether a hardship distribution is necessary to satisfy a financial need. Under this new standard, a hardship distribution must not exceed a participant’s need (including amounts to pay penalties and taxes), and the participant must not have any other way of meeting that need. To meet the second requirement,
the participant must take all other available distributions from the plan and from all deferred compensation plans of the employer,
the participant must represent that she has insufficient funds “reasonably available” to satisfy the financial need, and
the plan administrator cannot have actual knowledge that the participant’s representation is false.
The final regulations clarify that a participant can represent that she has insufficient funds even if she does have cash or other assets on hand—as long as she’s planning to use those assets on other future expenses (e.g., rent). The final regulations also clarify that in addition to a written representation, a participant can make a verbal representation through a recorded phone call.
Employers May Add Other Conditions, but Can’t Suspend Deferrals
In addition to the general standard described above, an employer may design its plan to require participants to meet additional conditions—such as taking a plan loan—before being eligible for a hardship distribution or requiring a nondiscriminatory minimum hardship distribution amount. Beginning January 1, 2020, however, an employer cannot require participants in a qualified plan, 403(b) plan, or governmental 457(b) plan to suspend employee contributions after receiving a hardship distribution.
While these three types of plans cannot suspend deferrals, the final regulations clarify that nonqualified deferred compensation plans may continue to include a suspension feature.
More Contribution Sources Available For Distributions
In addition to earnings on elective deferrals, other contribution sources in a participant’s 401(k) plan account may now be distributed for hardship reasons—including qualified nonelective contributions (QNECs), qualified matching contributions (QMACs), employer ADP safe harbor and QACA safe harbor contributions, and earnings on all of these amounts.
The new rules relating to hardship distributions also apply to 403(b) plans. However, earnings on 403(b) elective deferrals continue to be ineligible for hardship distribution and QNECs, QMACs, and other employer contributions continue to be unavailable in 403(b)(7) custodial accounts.
Other Issues
Using all safe harbor expenses not required
When determining if a participant has an immediate and heavy financial need, the final regulations clarify that employers may make available some but not all of the safe harbor expenses. The regulations also make clear that employers do not need to include all categories of individuals (e.g., primary beneficiaries) when determining who has a safe harbor expense.
Notice Requirements
The final regulations indicate that employers with ADP and/or ACP safe harbor plans must provide safe harbor notices that contain the hardship withdrawal provisions. If an employer’s current notice does not contain the new provisions, then the employer must provide an updated notice to eligible participants and provide participants with an opportunity to change their election.
Applicability Dates
The new hardship distribution rules apply to distributions taken on or after January 1, 2020, but employers may choose to apply the rules to distributions taken in plan years beginning after December 31, 2018.
The regulations allow employers to stop suspensions of contributions for hardship distributions taken in plan years after December 31, 2018. Employers may apply this rule as of the first day of the first plan year beginning after December 31, 2018, even if the hardship distribution was taken in the prior plan year (e.g., in October 2018.)
Amendment Deadlines
Although the amendment deadlines vary based on the type of plan document used, all amendments must apply to distributions taken no later than January 1, 2020.
At this point, the amendment deadline for pre-approved plan documents is unclear. The amendment deadline for individually designed plans (IDDs) depends on when the IRS includes the final regulations in the Required Amendments list. If the IRS includes the final regulations in the 2019 Required Amendments List, then employers must amend their IDDs by December 31, 2021.
For now, the 403(b) plan remedial amendment deadline is March 31, 2020. But the IRS and Treasury Department may issue separate guidance that provides for a later amendment deadline.
Next Steps…
Now that the final regulations have been released, service and document providers have begun analyzing the regulations with an eye toward updating their products and services. In the meantime, employers should become familiar with the revised hardship requirements and expect future amendments.
Visit ascensus.com for more industry news.
