On November 9, 2018, the IRS issued proposed amendments to the regulations under Code Section 401(k) that describe the circumstances under which participants may take an in-service distribution of elective deferrals (and contributions subject to similar withdrawal restrictions, such as QMACs, QNECs and safe-harbor contributions) on account of financial hardship. The proposed amendments to the regulations reflect several statutory changes to 401(k) plans since the Pension Protection Act of 2006, including the recent changes (that are scheduled to apply to hardship distributions in plan years beginning after December 31, 2018) under the Bipartisan Budget Act (“BBA”) of 2018. Most importantly, the amendments answer several questions that plan sponsors and plan administrators have had with respect to both the BBA and the Tax Cuts and Jobs Act (“TCJA”) of 2017, and provide some much-needed transition relief for hardship distributions made in 2019.
Background
Under Section 401(k) of the Code, contributions that are made pursuant to a qualified cash-or-deferred arrangement (i.e., elective deferrals, whether pre-tax or Roth) may be distributed only on or after the occurrence of one of the following events: death, disability, severance from employment, termination of the plan, attainment of age 59 ½, or financial hardship. Under the final 401(k) regulations that were issued in 2004, a distribution is made on account of hardship only if (i) the distribution is made on account of an “immediate and heavy financial need,” and (ii) the distribution does not exceed the “amount necessary” to satisfy the financial need. For each requirement, the regulations provide both a “general” standard (based on all applicable facts and circumstances), and a “safe-harbor” standard (circumstances under which the participant is “deemed” to have satisfied the applicable requirement). For example, the regulations currently list six specific categories of financial need (such as the need to pay medical expenses, or to pay college tuition for the next 12 months) that are “deemed” to constitute an immediate and heavy financial need, and the regulations currently specify that a distribution is deemed to be “necessary” if (i) the participant has first obtained all available loans and distributions from all qualified (and non-qualified) plans of the employer, and (ii) the participant is prohibited from making elective deferrals (or employee contributions) under any plan of the employer for the six-month period immediately following the hardship distribution.
The amendments made by the proposed regulations fall into three general categories: (i) expanding the types of contributions (and earnings) that may be distributed on account of financial hardship; (ii) modifying the “safe harbor” list of expenses that are deemed to constitute an “immediate and heavy financial need; and (iii) creating a single, new standard for determining whether a distribution is “necessary” to satisfy the participant’s financial need.
Amounts Distributable upon Hardship
The portion of a Participant’s account balance that may be distributed on account of financial hardship is expanded to include:
| 1. | Post-1988 earnings on elective deferrals under a 401(k) plan (but not earnings on elective deferrals under a Section 403(b) plan); and | |
| 2. | QNECs, QMACs, and “safe-harbor” contributions (and the earnings thereon) under 401(k) plans and 403(b)(1) annuity contracts (but not under 403(b)(7) custodial accounts). |
This expansion applies to hardship distributions made in plan years beginning on or after January 1, 2019. However, plans may continue to limit the types of contributions available for distribution on account of hardship after that date (meaning this change is “optional”).
Changes to the “Immediate and Heavy Financial Need” Safe-Harbor
The current (2004) regulations list six types of expenses that are “deemed” to constitute an immediate and heavy financial need. The proposed regulations:
| 1. | Clarify that damage to the participant’s primary residence due to a casualty loss that would otherwise be deductible under Code Section 165 (without regard to the percentage of AGI limitation) does not have to be in a federally-declared disaster area; | |
| 2. | Add the participant’s “primary beneficiary under the Plan” (in addition to the participant’s spouse or Tax Code dependent) as an individual for whom qualifying medical, educational and funeral expenses may be incurred; and | |
| 3. | Add a seventh (new) category of need for expenses or losses incurred as a result of certain disasters, such as hurricanes, floods, wildfires, etc., if the participant’s principal residence or principal place of employment at the time of the disaster was located in an area designated by the Federal Emergency Management Agency (FEMA) for individual assistance. |
These changes may be applied to distributions made on or after a date that is as early as January 1, 2018. (This “retroactive” effective date provides relief to those plans that chose not to limit 2018 hardship distributions on account of casualty damage to the participant’s principal residence to losses that occurred in presidentially-declared disaster areas.)
Complete Revision of the “Amount Necessary” Requirement
Statutory changes under the BBA eliminated the requirement that a participant obtain all non-taxable loans before taking a post-2018 plan year hardship distribution, and directed the IRS and Treasury to modify the 401(k) hardship rules to eliminate the requirement to suspend elective deferrals for at least six months after such hardship distributions. For plans using the “safe-harbor” approach, that would leave only the requirement that the participant receive all available distributions under the employer’s plans before taking a hardship distribution. In response, the proposed regulations completely eliminate the current “safe-harbor” for determining that the amount of the hardship distribution does not exceed the “amount necessary” to satisfy the participant’s financial need. The proposed regulations also eliminate the general or “facts and circumstances” standard under the current regulations. Both are replaced with a single new standard under which the following requirements must be satisfied in order to show that a distribution is “necessary” to satisfy the participant’s need:
| 1. | The distribution may not exceed the amount of the participant’s financial need (plus the anticipated taxes and penalties that the participant will incur as a result of the distribution); | |
| 2. | The participant must have obtained all other available distributions under the employer’s retirement plans; and | |
| 3. | The participant must represent, in writing, that he/she has insufficient cash or liquid assets to satisfy the financial need. |
The plan administrator is entitled to rely on the participant’s written representation in item 3, above, but only to the extent that the plan administrator does not have actual knowledge to the contrary.
This new standard generally applies to hardship distributions made in plan years beginning on or after January 1, 2019, although the representation in item 3 (regarding insufficient resources) is not required for distributions prior to January 1, 2020. The proposed regulations specifically provide that plans may impose additional conditions (such as the requirement to first obtain a participant loan). However, plans may not impose the six-month suspension of deferrals for distributions on or after January 1, 2020. Thus, with respect to these two statutory changes, the removal of the “loan first” requirement is essentially optional, whereas elimination of the six-month suspension of deferrals is optional in 2019, but mandatory in 2020 and future years. And, the new requirement to obtain the participant’s certification regarding insufficient resources is essentially optional in 2019, but required for distributions in 2020 and beyond.
The proposed regulations also provide that plans may discontinue the practice of suspending post-hardship deferrals effective the first day of the first plan year beginning on or after January 1, 2019, even with respect to hardship distributions made during the last half of the previous plan year. However, plan sponsors (and their service providers) will have to determine whether it is administratively feasible to apply the new rule in that manner, or whether discontinuance of the six-month suspension rule should apply solely to hardship distributions made on or after a date that is between the first day of the 2019 plan year and January 1, 2020.
Conclusion
The proposed amendments to the 401(k) regulations regarding hardship distributions answer most, if not all, of the questions that plan sponsors and administrators have been asking about the new hardship distribution rules under the TCJA and the BBA, and provide useful transition relief for plan sponsors of 401(k) plans and 403(b) arrangements. If you have any questions about the proposed hardship regulations, or how they apply to your company’s retirement plan, please contact any of the attorneys in the Employee Benefits Practice Group at Spencer Fane.
This post was drafted by Rob Browning, an attorney in the Kansas City, MO office of Spencer Fane LLP. For more information, visit spencerfane.com.