IRS Provides New Guidelines for Documenting Hardship Distributions
On February 23, 2107, the IRS issued a memorandum to field agents with new guidelines related to documentation considered as acceptable substantiation of a hardship distribution from an Internal Revenue Code (“IRC”) section 401(k) plan. The guidance applies only to whether a 401(k) plan hardship distribution is “deemed to be on account of an immediate and heavy financial need” under the safe-harbor standards provided in the section 401(k) regulations. It does not apply to the substantiation requirements of non-safe-harbor hardship distributions under section 401(k).
A 401(k) plan document may specifically allow hardship distributions, allowing a participant to receive a distribution of elective contributions from the plan on account of financial hardship. A distribution is considered a hardship distribution only if it is made on account of an immediate and heavy financial need of the employee and is necessary to satisfy the financial need.
Under the safe-harbor provisions for hardship distributions, a distribution is deemed to be on account of an immediate and heavy financial need if it is made for one or more of the following reasons:
- Expenses for medical care deductible under IRC section 213(d) for the employee or the employee’s spouse, children, dependents, or primary beneficiary under the plan;
- Costs directly related to the purchase of a principal residence;
- Payment of tuition, related educational fees, and/or room and board expenses for up to the next 12 months of post-secondary education for the employee or the employee’s spouse, children, dependents, or primary beneficiary under the plan;
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence;
- Payments for burial or funeral expenses for the employee’s deceased parents, spouse, children, dependents, or primary beneficiary under the plan; or
- Expenses for the repair of damages to the employee’s principal residence that would qualify for the casualty deduction under IRC section 165. A participant must provide documentation to substantiate that the distribution is for one of the above items.
The memorandum requests that field agents follow a 2-step approach in determining if a hardship distribution was made on account of a deemed immediate and heavy financial need as described below.
- Determine whether the employer or third-party administrator, prior to making a distribution, obtains: (a) source documents (such as estimates, contracts, bills and statements from third parties); or (b) a summary (in paper, electronic format, or telephone records) of the information contained in source documents.
- If a summary of information in source documents is used as substantiation, determine whether the employer or third-party administrator provided the required notifications prior to making a hardship distribution. The notifications must provide the following:
- The hardship distribution is taxable and additional taxes could apply.
- The amount of the distribution cannot exceed the immediate and heavy financial need.
- Hardship distributions cannot be made from earnings on elective contributions or from qualified non-elective contributions (“QNEC”) or qualified matching contributions (“QMAC”) accounts, if applicable.
- The employee agrees to preserve source documents and to make them available at any time, upon request, to the employer or administrator.
- If the employer or third-party administrator obtains source documents as described under Step 1, review the documents to determine if they substantiate the hardship distribution.
- If the employer or third-party administrator obtains a summary of information on source documents under Step 1, review the summary to determine whether it contains the relevant documentation listed in Attachment I (see IRS memorandum for a complete list of documentation).
The guidance provides that if the notification provided to employees in Step 1 or the information reviewed in Step 2 is incomplete or inconsistent on its face, the agent may ask for source documents from the employer or third-party administrator.
Further, if the summary of information reviewed by the agent in Step 2 is complete and consistent, but the agent finds employees who have received more than 2 hardship distributions in a plan year, then, in the absence of an adequate explanation for the multiple distributions and with managerial approval, the agent may ask for source documents from the employer or third-party administrator to substantiate the distributions. Examples of an adequate explanation for multiple distributions include follow-up medical or funeral expenses or tuition on a quarterly school calendar.
If a third-party administrator, rather than the employer, obtains a summary of information contained in source documents under Step 1, the agent is to determine whether the third-party administrator provides a report or other access to data to the employer, at least annually, describing the hardship distributions made during the plan year.
The IRS memorandum provides useful information regarding the documentation that employers should be obtaining and retaining to demonstrate that hardship distributions made by their 401(k) plan were on account of an immediate and heavy financial need. Employers should review their hardship documentation procedures in light of the IRS memorandum to confirm that the documentation being obtained is adequate for substantiating an employee’s hardship.