The Bipartisan Budget Act of 2018 liberalized the rules applicable for hardship distributions in 401(k) plans. These changes impact the “safe harbor” hardship distribution rules (the ones most commonly used in plans) and will generally become effective for plan years beginning after December 31, 2018.
To assist plan sponsors with implementing these changes, the IRS issued proposed regulations in November 2018, and after months of public comment, issued final regulations on September 23, 2019.
In general, the new rules make it easier for participants to qualify for hardship distributions, expand the sources available for such distributions, and remove the 6-month deferral suspension period following a hardship distribution. They also make it easier on plan sponsors by simplifying the substantiation process.
What qualifies for a hardship distribution under the new rules?
Under the existing rules, hardship distributions may only be made from a participant’s 401(k) and/or Roth account for the following:
- Unreimbursed, tax-deductible medical expenses (without regard to the deduction limitation);
- Certain costs associated with the purchase of a participant’s principal residence;
- Post-secondary educational expenses for a participant, his or her spouse, children or dependents (for the next 12 months);
- Funeral expenses for a participant’s spouse, parents, children or dependents;
- Expenses necessary to repair damage to a participant’s principal residence incurred as a result of a casualty (tax-deductible loss); and
- Amounts necessary to prevent foreclosure or eviction from a participant’s principal residence.
Under the new rules, the conditions under which a participant can obtain a hardship distribution have been expanded to include the following:
- Expenses incurred as a result of a natural disaster in a federally-declared disaster area; and
- Medical, post-secondary educational, and funeral expenses for a participant’s primary beneficiary.
Additionally, the proposed regulations clarify that if a participant’s principal residence is damaged as a result of a casualty, such as a fire or windstorm, it is not necessary for the participant’s home to be in a federally-declared disaster area. When the income tax law changed, it impacted the hardship distribution rules since the 401(k) regulations (current) require the casualty loss be tax-deductible.
What contribution types are available for hardship distributions?
Under the existing rules, hardship distributions can only be made from a participant’s 401(k) and/or Roth account, excluding any related earnings. In other words, a participant can only withdraw his or her contributions.
Under the new rules, the amount available for hardship distributions will include related earnings. In addition, Plan Sponsors may allow participants to take hardship distributions from safe harbor account balances as well as QNEC or QMAC account balances, if provided for under the terms of the plan document.
Note: Some plans permit hardship distributions that fell outside of the definition of “Safe Harbor” hardship distributions, which allowed distributions from other sources, such as profit sharing or matching account balances. These contribution sources are not “restricted” from taking in-service distributions prior to attainment of age 59 ½ (like 401(k), Roth, safe harbor, QNEC and QMAC account balances), so these distribution rules have not changed; it is still permissible to allow for hardship distributions from these accounts, if provided for under the terms of the plan document.
How much can a participant receive as a hardship distribution?
The amount cannot exceed the lesser of (1) a participant’s financial need (grossed up for applicable income taxes), or (2) his or her available account balance. This rule has not changed, although the amount available has been expanded to include related earnings and additional contribution sources.
What substantiation is required for hardship distributions?
The proposed regulations provide new standards for determining whether a hardship distribution is deemed necessary to meet a participant’s financial need.
- The participant must have obtained all other available in-service distributions under any plans maintained by the employer; and
- The participant must represent that he or she does not have enough liquid assets to satisfy the financial need.
Currently, a participant is generally required to take a loan from the plan (if available) prior to receiving a hardship distribution, and the determination of whether a hardship distribution is deemed necessary to meet an “immediate and heavy” financial need is based on all relevant facts and circumstances.
The new standards remove the plan loan requirement and simplify the process for plan sponsors as they can rely on the participant’s representation, absent actual knowledge to the contrary.
How will the new rules for the 6-month deferral suspension apply?
Under existing rules, plans are required to suspend participant deferrals for a period of 6 months following a hardship distribution. Under the new rules, plans will no longer be permitted to suspend participant deferrals.
Although there was flexibility in implementing these changes for 2019, for hardship distributions made on or after January 1, 2020, plans will be prohibited from imposing the 6-month suspension period.
When are these changes effective?
Generally, these changes are effective for plan years beginning after December 31, 2018. Again, there are special rules that apply for certain purposes such as the 6-month suspension period.
Will these changes require a plan amendment?
Yes, these changes will require a plan amendment. It appears that plan sponsors will be able to implement the new rules prior to amending their plan, though. The IRS has made it clear that the plan need not be amended by the end of the 2019 Plan Year to remain in compliance, provided the amendment is adopted by the end of the 2020 Plan Year. For Plan Sponsors on the EJReynolds pre-approved (prototype) documents, we are in the process of preparing those amendments and expect to have those out by the end of second quarter of 2020.
How can I learn more about these requirements?
Please contact the Plan Consultants at EJReynolds to learn more about how these rules impact your plan and participants!