Are You Ready? Proposed Regulations on Hardship Distributions

In late 2018, the Internal Revenue Service ("IRS") issued proposed regulations ("Proposed Regulations") regarding hardship distributions from 401(k) and 403(b) plans. Beginning on January 1, 2020, plans must operationally comply with some of the key provisions of these Proposed Regulations. In addition, plans must be amended by December 31, 2019 to reflect any optional changes implemented in 2019.

WHAT DO I NEED TO KNOW?

Existing Treasury regulations dictate when 401(k) plans and 403(b) plans may permit hardship distributions. A hardship distribution must be:
 

1. made on account of an "immediate and heavy" financial need; and
2. necessary to satisfy the financial need.

In general, whether a participant's financial need is "immediate and heavy" and "necessary" is determined based on all facts and circumstances. However, existing regulations offer a safe harbor for determining whether the two requirements have been satisfied.

Under the existing safe harbor, six types of expenses are automatically deemed to be requested on account of an "immediate and heavy" financial need:
 

1. medical care described in Internal Revenue Code (“Code”) § 213(d) for the employee, the employee's spouse or the employee's dependents (regardless of whether the expenses exceed 7.5% of adjusted gross income);
2. costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);
3. payment of tuition, related educational fees, and room and board expenses for up to the next 12 months of postsecondary education for the employee, the employee's spouse, or the employee’s children or dependents;
4. payments necessary to prevent the eviction of the employee from the employee's principal residence or to prevent foreclosure on the mortgage on that residence;
5. payments for burial or funeral expenses for the employee's deceased parent, spouse, children or dependents; or
6. expenses for the repair of damage to the employee's principal residence that would qualify for the casualty deduction under Code § 165 (determined without regard to whether the loss exceeds 10% of adjusted gross income).

Recap of the Proposed Regulations

Expansion of Safe Harbor Rules for "Immediate and Heavy" Financial Need

The Proposed Regulations expand the list of expenses for which hardship distributions are deemed to be made on account of an "immediate and heavy" financial need to include the following:
 

1. Addition of Expenses for Primary Beneficiaries. Medical, educational and burial/funeral expenses now include those incurred for the participant's "primary beneficiary under the plan," meaning an individual who is named as a beneficiary under the plan and has an unconditional right to all or a portion of the employee’s plan account balance upon the employee’s death.
2. Expenses Incurred as a Result of Certain Disasters. Expenses and losses (including loss of income) incurred by the employee on account of a disaster declared by the Federal Emergency Management Agency ("FEMA"), if the employee's principal place of residence or employment at the time of the disaster was located within an area designated by FEMA for individual assistance.
3. Casualty Loss. Damage to a principal residence that would qualify for a casualty deduction under Code § 165 is no longer required to be in a federally declared disaster area, which eliminates the limitation imposed by the Tax Cuts and Jobs Act.

Elimination of Prohibition on Contributions
 
Existing regulations prohibit a participant from making employee contributions after receiving a hardship distribution. The Proposed Regulations eliminate this requirement for distributions made on or after January 1, 2020. They also prohibit plans from suspending participant contributions after the participant receives a hardship distribution. This prohibition is mandatory only for distributions made on or after January 1, 2020.

Elimination of Requirement to Take Available Loans
 
Existing regulations require a participant to take all available plan loans prior to receiving a hardship distribution. The Proposed Regulations eliminate this requirement.

Expansion of Contribution Sources for Hardship Distributions
 
The Proposed Regulations permit, but do not require, 401(k) plans—but not 403(b) plans—to allow participants to take hardship distributions from participant elective deferrals, qualified non-elective contributions, qualified matching contributions and/or the earnings on those contributions. Qualified non-elective contributions and qualified matching contributions held in a custodial account continue to be ineligible for hardship distributions.
 
Elimination of Facts and Circumstances Test

Under existing regulations, if a plan does not rely on the safe harbor rules, the plan administrator must determine whether the claimed need is "immediate and heavy" and "necessary" based on individual facts and circumstances.

The Proposed Regulations eliminate this facts and circumstances test and replace it with a three-part test ("Three-Part Test"). The Three-Part Test requires:
 

1. Not in Excess of Need. The hardship distribution may not exceed the amount of a participant's financial need (including any amounts necessary to pay taxes or penalties reasonably anticipated to result from the distribution);
2. Obtained Other Available Distributions. The participant must have obtained other available distributions under the employer’s plans before taking the hardship distribution; and
3. Insufficient Liquid Assets. The participant must represent that he or she has insufficient cash or other liquid assets to satisfy the financial need.

Plan administrators have been allowed to apply the Three-Part Test since January 1, 2019, but the requirement to obtain a participant’s representation of insufficient liquid assets becomes mandatory for hardship distributions made on or after January 1, 2020.

WHAT DO I NEED TO DO?
 

1. Prepare for operational compliance. Plan administrators should prepare to comply operationally with the Proposed Regulations mandatory changes.
2. Amend plans for implemented changes. Plan sponsors that have elected to implement optional changes in 2019 should amend their plans by December 31, 2019 to reflect these changes.

If you have any questions about the new hardship distribution requirements, please contact Gary Blachman, Kathleen Sheil Scheidt, Marc Sciscoe, Audra Ferguson-Allen, Melissa Proffitt, Tara Sciscoe, Sara Funke, Austin Anderson, or your Ice Miller LLP Employee Benefits attorney.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.