Final Regulations on Hardship Distributions Make Few Changes to Proposed Regulations

On September 19, 2019, the Treasury Department issued the final regulations governing hardship distributions under 401(k) and 403(b) plans. The finalized hardship regulations, which relax some of the rules governing hardship withdrawals, contain few differences from the proposed regulations released on November 9, 2018.

As noted in our prior e-alerts (issued on November 28, 2018 and July 18, 2019), 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.

Changes from the Proposed Regulations

Relaxed Employee Representation Requirement. The proposed regulations required that a participant make a representation that he/she has insufficient cash or other liquid assets to cover expenses resulting from a hardship. The final regulations relax this requirement by providing that the participant must represent only that he or she has insufficient cash or other liquid assets reasonably available to cover expenses resulting from a hardship. The IRS explained the revision allows an employee to represent that he/she meets the requirement even though the participant may have some cash on hand, reserved for another future obligation, such as rent.

Employee Representations by Email, Telephone, and Website are Acceptable. The finalized regulations clarify that the required employee representation regarding the need for a hardship distribution may be made by "electronic medium" and define "electronic medium" by reference to Treasury Regulation 1.401(a)-21(e)(3). Under this regulation, an "electronic medium" is "an electronic method of communication (e.g., website, electronic mail, telephonic system, magnetic disk, and CD-ROM)." Thus, for example, plan administrators may establish an electronic process for receiving employee representations through email or an intranet site.

Prohibition on Deferral Suspension Does Not Apply to Unfunded Nonqualified Plans. The finalized regulations clarify that the prohibition on deferral suspension applies to qualified plans, section 403(b) plans, and eligible 457(b) plans, but it does not apply to unfunded nonqualified plans, such as those subject to Internal Revenue Code ("Code") Section 409A.

What Do I Need to Know?

Treasury regulations dictate when 401(k) 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.

Prior to the finalized regulations, under the safe harbor, there were six types of expenses automatically deemed to be requested on account of an "immediate and heavy" financial need:
 

1. medical care described in 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 Regulations

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

The 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 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 regulations eliminate this requirement.

Expansion of Contribution Sources for Hardship Distributions

The 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 nonelective contributions, qualified matching contributions, and/or the earnings on those contributions. Qualified nonelective 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 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 regulations mandatory changes.
2. Amend Plans for Implemented Changes. Plans sponsors who have elected to implement optional changes in 2019 should amend their plans by December 31, 2019 to reflect these changes. The deadline for amending the plan is the end of the second calendar year that begins after the issuance of the Required Amendments List (RAL) that includes the change. For example, if the final regulations are included in the 2019 RAL, the deadline will be December 31, 2021.

If you have any questions about the new hardship distribution requirements, please contact Audra Ferguson-Allen, Robert Gauss, Lisa Harrison, Lindsay Knowles, Tara Sciscoe, Chris Sears, or the Ice Miller LLP Employee Benefits attorney with whom you most closely work.

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.