3798 / What requirements apply to hardship withdrawals from a 401(k) plan?

Editor’s Note: The SECURE Act 2.0 created new rules allowing plan participants to take emergency distributions to cover immediate financial hardships without penalty. These emergency distributions will be limited to $1,000 each year. Also, taxpayers who take emergency distributions must repay the distribution within a three-year period or will be prohibited from taking another $1,000 distribution during the following three-year period. Non-highly compensated employees may be entitled to contribute the le sser of (1) 3% of compensation or (2) $2,500 to pension-linked emergency savings accounts (PLESAs) using after-tax dollars if their employer elects to establish a PLESA. See Q3798.1 for details.
The 2017 tax reform legislationcreated new rules governing hardship distributions made because of qualified 2016 disasters. The CARES Act further expanded hardship distribution eligibility in response to the COVID-19 pandemic in 2020. See Q3799-Q3801 for details.

Hardship withdrawals may be made from a 401(k) plan only if the distribution is made on account of an immediate and heavy financial need and the distribution is necessary to satisfy the financial need.² The distribution may not exceed the employee’s maximum distributable amount. Hardship withdrawals generally may not be rolled over ( Q 3998).³ Not all plans provide for hardship withdrawals, and plan sponsors must first look to the plan documents before determining whether a hardship distribution can be made. The final regulations cited here took effect for plan years beginning on or after January 1, 2006.⁴

The Pension Protection Act of 2006 called for regulations modifying the hardship requirements to state that if an event constitutes a hardship with respect to a participant’s spouse or dependent, it constitutes a hardship with respect to the participant, to the extent permitted under the plan.⁵

An employee’s maximum distributable amount generally is equal to the employee’s total elective contributions as of the date of distribution reduced by the amount of previous distributions on account of hardship.⁶ Early in 2018, Congress passed the Bipartisan Budget Act of 2018 (BBA 2018), which modified this rule to expand the amounts that may be withdrawn as hardship distributions. Beginning in tax years that begin after December 31, 2018, the following amounts may also be distributed as hardship distributions (1) amounts contributed by the employer to a profit sharing or stock bonus plan, (2) qualified nonelective contributions (QNECs), (3) qualified matching contributions (QMACs) and (3) earnings on any of these types of contribution.⁷

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Planning Point: The changes enacted by BBA 2018 are not all mandatory, meaning that plan sponsors have the option of modifying their plans to implement the new rules.Plan sponsors operating safe harbor 401(k)s may wish to proceed with caution in implementing the changes, as Treasury has yet to issue guidance on whether the regulatory safe harbor will be satisfied if the plan retains (1) the six-month waiting period for contributions following a hardship distribution or (2) the requirement that the participant first take a plan loan before a hardship distribution is available.Plans must also consider the “leakage” problem in allowing participants to withdraw QNECs or QMACs, or in permitting hardship distributions before plan loans (which must be repaid).

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The determinations of whether the participant has “an immediate and heavy financial need” and whether other resources are “reasonably available” to meet the need are to be made on the basis of all relevant facts and circumstances. Beginning for hardship distributions taken on or after January 1, 2020, the employee must provide a written representation stating that the employee does not have cash or other liquid assets reasonably available to satisfy the need (under BBA 2018). An example of “an immediate and heavy financial need” is the need to pay funeral expenses of a family member. A financial need will not fail to qualify as an immediate and heavy financial need merely because it was foreseeable or voluntarily incurred by the employee.⁸

Under the SECURE Act 2.0, beginning in 2023, employers are permitted to rely on written self-certification from employees stating that (1) the hardship exists, (2) the amount requested does not exceed the amount needed to cover permitted expenses and (3) the employee does not have a reasonably available alternative source of funding.

A distribution will be deemed to be made on account of “an immediate and heavy financial need” if it is made on account of any of the following:

(1) “medical expenses” incurred by the employee, spouse, or dependents that would be deductible as itemized deductions under section 213(d) without regard to the 7.5 percent (10 percent in prior years⁹) of AGI floor;

(2) the purchase (excluding mortgage payments) of the employee’s principal residence;

(3) payment of tuition, related educational fees, and room and board expenses for the next 12 months of post-secondary education for the employee, spouse, children, or dependents (note that the educational expenses must be for education incurred in the following 12 months, the IRS has ruled that a participant cannot take a hardship distribution to repay student loans incurred for past education);

(4) payments necessary to prevent eviction of the employee from his or her principal residence or foreclosure on the mortgage on his or her principal residence;

(5) funeral or burial expenses for the employee’s parent, spouse, children, or other dependents (as defined prior to 2005); and

(6) expenses for the repair or damage to the employee’s principal residence that would qualify for the casualty deduction under IRC Section 165 (without regard to the 10 percent floor).¹⁰

This list may be expanded by the IRS but only by publication of documents of general applicability.¹¹ Apparently, to be the taxpayer’s “principal residence” for this purpose, the home must be the residence of the employee, not merely that of his or her family.¹²

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Planning Point: While the rules governing plan hardship distributions were not directly changed by the 2017 tax reform legislation, many plans that follow safe harbor standards and allow participants to withdraw funds to cover losses that are deductible as casualty losses may need to reevaluate their plan provisions.This is because, for 2018025, individuals may only treat losses sustained in a federal disaster area as deductible casualty losses under IRC Section 165.Unless subsequent guidance is released to change the safe harbor rules governing hardship distributions, plans may need to change the terms of their plan to comply with the new Section 165 rules.

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A distribution is not necessary to satisfy such an immediate and heavy financial need (and will not qualify as a hardship withdrawal) to the extent the amount of the distribution exceeds the amount required to relieve the financial need. The amount of an immediate and heavy financial need may include any amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution.¹³

The distribution also will not be treated as necessary to satisfy an immediate and heavy financial need to the extent the need can be satisfied from other resources that are reasonably available. However, the BBA 2018 eliminated the requirement that a plan participant first take any available plan loan before the distribution could qualify as a hardship distribution.¹⁴

A distribution may be treated as necessary if the employer reasonably relies on the employee’s representation that the need cannot be relieved:

(1) through reimbursement or compensation by insurance or otherwise,

(2) by reasonable liquidation of the employee’s assets,

(3) by cessation of elective contributions or employee contributions,

(4) by other distributions or nontaxable loans from any plans (the requirement that a participant first take any available plan loan was eliminated by the BBA 2018, but the requirement that the employee consider any ESOP dividend distributions was retained), or

(5) by loans from commercial sources.

Notwithstanding these provisions, an employee need not “take counterproductive actions” (such as a plan loan that might disqualify the employee from obtaining other financing) if the effect would be to increase the amount of the need.¹⁵

The final regulations governing hardship distributions also provide that with respect to employee representations of financial hardship, the employee can reasonably represent that he or she has no cash or liquid assets reasonably available to satisfy the relevant financial need if the only cash or liquid assets available to that employee are necessary to pay some other expense (such as rent) in the near future.¹⁶ Employees can also make representations of financial need over the phone if the employer records the call.¹⁷ Plan documents were required to be amended by December 31, 2021 to provide for the new written representation provision, although the rule is effective beginning in 2020.¹⁸

Plan sponsors are also entitled to impose a minimum distribution amount for hardship distributions so long as the requirement is not found to be discriminatory.¹⁹

Regulations state that a distribution will be deemed to be “necessary” to meet a financial need (deemed or otherwise) if the employee has obtained all other distributions and nontaxable loans (prior to 2019) currently available under all of the employer’s plans and, prior to 2019, the employee is prohibited from making elective contributions and employee contributions to the plan and all other plans of the employer for a period of at least six months after receipt of the hardship distribution.²⁰The regulations have been modified to eliminate the prohibition on contributions during the six month period following receipt of a hardship distribution, although the final regulations have clarified that the new rule applies only to contributions to qualified plans. Plan documents must be amended by December 31, 2021 to account for this new rule, which became effective beginning in 2020.²¹ Nonqualified plans, including those subject to IRC Section 409A, may continue to suspend deferrals for six months following the hardship distribution.²²

The IRS has released internal guidance that it will use when examining a 401(k) plan to evaluate whether hardship distributions have been properly substantiated. The new guidance clarifies that, as part of the verification process for determining whether the participant has an immediate and heavy financial need, the employer or plan sponsor must review either the source documents supporting that need (such as contracts or foreclosure notices), or a summary of those documents. If only a summary is provided, an IRS agent reviewing the case will look to whether a notice was provided to the withdrawing participant before he or she is entitled to the hardship withdrawal. The notice must contain a statement that provides the following information:

(1) the distribution is taxable,

(2) additional taxes could apply,

(3) the amount of the distribution cannot exceed the participant’s “immediate and heavy financial need,”

(4) the distribution cannot be made from earnings on elective contributions or qualified nonelective contributions or matching contributions (QNECs and QMACs) (the prohibition on making the distribution from QNECs, QMACs, and earnings was eliminated for tax years beginning after December 31, 2018)²³, and

(5) all source documents must be retained and provided to the employer or administrator upon request at any time.

The guidance also provides that specific information should be obtained by the plan administrator to substantiate a summary. If the summary is incomplete or inconsistent on its face, the IRS examining agent may ask for source documents.²⁴