Sorting Out Hardship Distributions
By Lisa Haberman, MBA, MAM
We administer employer-sponsored retirement plans that allow for hardship distributions and are somewhat confused about the hardship rules after the recent legislative and regulatory changes.
The hardship distribution rules can be confusing—especially after the changes created by the Bipartisan Budget Act of 2018 (BBA). While this legislation was welcomed by retirement plan participants, it created added complexity for employers and plan administrators dealing with hardship distributions taken on or after January 1, 2020.
BBA relaxed the rules for when participants may take a hardship distribution, but it also required the IRS to create regulations—proposed in 2018 and made final in 2019—for plans to follow when processing hardship distribution requests. Some of the key regulatory changes created to support the BBA statutes include
amending the deemed safe harbor rule standard,
expanding the contribution sources available to take a hardship distribution,
allowing hardship distributions without requiring participants to first take an available loan, and
eliminating the six-month deferral suspension after taking a hardship.
What changes were made to the safe harbor hardship distribution standard?
Prior to the BBA, true hardship distributions consisted only of employee salary deferral contributions, not including their earnings. (Some employers allowed in-service distribution of employer contributions, like profit sharing and match, and limited these to hardship situations, but these were not true hardship distributions in the regulatory sense.) The BBA has expanded the contribution sources from which hardship distributions may now be taken, and earnings may now be distributed under a qualifying hardship. It’s important to note, however, that plans are not required to offer hardship distributions. Because of this, they have significant latitude in defining the circumstances under which they will permit them, from which eligible contribution sources they may be taken, etc.
For a distribution to be taken because of financial hardship, the reason for the distribution must meet two requirements.
It must be made on account of an immediate and heavy financial need of the participant.
The amount must be necessary to satisfy the financial need.
These requirements may be determined in two different ways: using the general rule or the deemed safe harbor rule. A customized or individually designed plan may use either the general rule or the deemed safe harbor rule to determine whether an employee’s financial hardship meets both criteria, while an unmodified pre-approved retirement plan document must always use the deemed safe harbor rule.
Under the general rule, the plan administrator must look at all relevant facts and circumstances to determine whether an employee has an immediate and heavy financial need. The employer must consider all of a participant’s financial resources to determine if a hardship distribution is necessary to satisfy the financial need. The general rule requires a plan administrator to consider whether the employee’s financial hardship may be adequately met by leveraging other financial resources, including resources outside of the plan (e.g., a savings account, certificates of deposit, loans). If other resources are available to the employee, the plan administrator must deem the hardship distribution unnecessary.
Under the deemed safe harbor rule, a hardship distribution is automatically considered to meet both criteria of immediate and heavy financial need and necessary to satisfy the financial need if made for expenses related to any of the following.
Medical
Principal residence purchase
Education
Eviction/foreclosure prevention
Funeral/burial
Casualty loss
Federal disaster declaration
Federal disaster declaration was added to the list of safe harbor reasons when the IRS finalized the hardship distribution regulations in September 2019 for expenses and losses incurred by an employee on or after January 1, 2018, if the participant’s principal residence or place of employment was in a FEMA-declared disaster area.
In addition to the above-identified circumstances being deemed to satisfy the hardship rules for a plan participant, medical, educational, and funeral expenses for a primary beneficiary also meet these requirements.
Is casualty loss still an available safe harbor hardship distribution reason?
The casualty loss safe harbor reason is currently available, regardless of whether the participant qualifies for the casualty loss income tax deduction or whether the participant’s primary residence is in a FEMA-declared disaster area.
The Tax Cuts and Jobs Act (TCJA 2017) eliminated the casualty loss income tax deduction for tax years 2018–2025 unless the casualty loss occurred within a federally declared disaster area. Because of the statutory link to that tax deduction for claiming a casualty-based hardship, this seems to eliminate a plan participant’s ability to qualify for a hardship distribution under that safe harbor. Fortunately, the final hardship regulations restored the ability for plan participants to take a hardship distribution due to casualty loss to their primary residence without the requirement of being eligible for a tax deduction.
Can hardship distributions be taken from any asset source in the plan?
Thanks to the BBA changes, plan participants are allowed to take hardship distributions from more contribution sources, including not only elective deferrals—as before—but also qualified nonelective contributions (QNECs), qualified matching contributions (QMACs), employer actual deferral percentage (ADP) and qualified automatic contribution arrangement (QACA) safe harbor contributions, and the earnings from these sources.
These expanded contribution sources for hardship distributions also apply to 403(b) plans, with two exceptions: the earnings on 403(b) elective deferrals are not available for hardship distributions, nor are QNECs and QMACs in 403(b)(7) custodial (non-annuity) accounts.
Is it true that plan participants are not required to take a loan from the plan before requesting a hardship distribution?
Yes. Before the BBA, plan participants were required to take any available loan from the plan before requesting a hardship distribution. As of January 1, 2020, this is no longer required—unless a decision is made that the plan will continue the requirement, at its option.
Do plan participants need to suspend their elective deferrals after taking a hardship distribution?
As of January 1, 2020, employers may no longer require qualified plan, 403(b), or 457(b) plan participants to suspend their deferral elections after taking a hardship distribution. This component of the final regulations was optional for the 2019 plan year, but it is now mandatory for 2020 and later plan years.
