In recent years, sponsors and administrators of 401(k) and 403(b) plans have received conflicting advice on the steps they should take to substantiate an employee’s entitlement to an in-service withdrawal on account of financial hardship. For instance, an April 2015 IRS newsletter seemed to require that plan sponsors obtain and retain documentary proof of an employee’s entitlement to a hardship withdrawal. We summarized that guidance in our April 6, 2015, article. However, two recent internal IRS memos outline a permissible approach to this substantiation requirement that need not involve conditioning a hardship withdrawal on an employee’s provision of supporting documents. Plan sponsors should thus consider this new alternative.
Background on Hardship Withdrawals
In order to encourage retirement savings, the Tax Code generally prohibits active employees from obtaining a distribution of their elective deferrals under either a 401(k) or 403(b) plan. One exception to this in-service withdrawal restriction applies, however, on an employee’s showing of financial hardship. Because a failure to allow for hardship withdrawals may discourage participation altogether, most sponsors of these plans do offer this option.
Moreover, as technology changed the way 401(k) and 403(b) plans were administered, many such plans began to allow employees to self-certify their entitlement to a hardship withdrawal. The IRS became uncomfortable with this approach, however, viewing it as a way of allowing employees to circumvent the Tax Code restrictions. Hence, the 2015 newsletter guidance.
The Latest IRS Guidance
In response to the 2015 newsletter, plan sponsors and administrators sought further IRS guidance on the substantiation requirements. That guidance came in two internal memos to IRS agents – a February 23, 2017, memo concerning audits of 401(k) plans and a March 7, 2017, memo concerning 403(b) plan audits. In all substantive respects, the two memos are identical. Although both memos note that they are not intended as pronouncements of law and may not be relied upon as such, it seems inconceivable that an IRS agent would penalize a plan sponsor for choosing to follow the procedures outlined in the memos.
Those procedures are specifically limited to the “safe harbor” rules governing hardship withdrawals. For a variety of reasons, however, most plans do rely on those rules. They require that any hardship withdrawal satisfy two separate prongs:
- Any hardship withdrawal must be “on account of” one of six specified hardship events; and
- The amount to be withdrawn must be “necessary to satisfy” that particular hardship (i.e., the employee must have no other ready alternative for doing so).
The IRS regulations specifically allow a plan to rely on an employee’s representations on the “necessary to satisfy” prong. What the recent IRS guidance does is allow for similar reliance with respect to the “on account of” prong – though subject to a number of conditions.
As spelled out in IRS regulations, the six safe-harbor purposes for which a hardship withdrawal may be obtained are as follows:
- Medical care;
- Purchase of a principal residence;
- Post-secondary education expenses;
- Prevention of eviction from, or foreclosure on, a principal residence;
- Burial or funeral expenses; and
- Repair of damages to an employee’s principal residence.
The recent memos make clear that, before granting a hardship withdrawal for any of these six reasons, a plan must first obtain either
- Source documents (such as estimates, contracts, bills, or statements from third parties); or
- An employee’s summary of the information contained in those source documents. (This summary may be provided on paper, electronically, or even by telephone.)
If a plan requests the actual documents, the only further requirement is to review those documents to verify that they support the requested hardship withdrawal (including the amount requested).
However, before relying on an employee’s summary of the underlying documents, the plan must first (1) notify the requesting employee of various items of information, and then (2) obtain both general information concerning the participant and his or her request and more specific information concerning the event cited as justifying the hardship withdrawal. These required notifications and information requests are itemized in an attachment to each of the recent memos.
In particular, a plan that relies on employee summaries of the underlying documents must notify each employee requesting a hardship withdrawal that
- The amount withdrawn will be subject to income taxation, and could also trigger additional taxes (such as the 10% tax on distributions made before age 59½);
- The amount of the withdrawal cannot exceed the immediate and heavy financial need;
- Only actual salary deferrals may be withdrawn for financial hardship – i.e., excluding any earnings or “qualified nonelective contributions”; and
- The recipient of the withdrawal must agree to preserve the underlying source documents and then make them available to the plan upon request (for instance, in the event of an IRS audit).
Each employee requesting a hardship withdrawal must then be asked to provide the following general information:
- The employee’s name;
- The total cost of the event causing the financial hardship;
- The amount of the withdrawal requested; and
- A certification by the employee that the information provided is true and accurate.
Depending on the specific hardship-withdrawal event, the requesting employee must also be asked to provide four to seven additional items of information. For instance, an employee requesting a withdrawal to pay educational expenses must provide the following information:
- The name of the individual obtaining the education;
- That individual’s relationship to the employee;
- The name and address of the educational institution;
- The types of educational expenses involved (e.g., tuition, related fees, or room and board); and
- The period covered by the educational payments (no more than 12 months).
Plan Sponsor Decision
Sponsors of 401(k) or 403(b) plans that allow for hardship withdrawals should now decide whether they wish to take advantage of this latest IRS guidance. Plans that have been relying on employee self-certifications should certainly do so. By providing the appropriate notice and obtaining the specified information, such self-certifications may be continued.
Plans that now request documentation to support each hardship withdrawal should consider whether to begin obtaining only summaries of the underlying documents. Doing so would streamline the hardship-withdrawal process – both for employees and for the individuals administering the plan. Implementing this new approach, however, would likely require changes to forms and/or websites. It might also require revisions to participant communications – including the plan’s summary plan description.