401(k) Hardship Withdrawals: Proposed Regulations Provide Favorable and Generally Expected News for Plan Sponsors and Participants

The Internal Revenue Service (IRS) recently¹ published proposed regulations covering 401(k) hardship distributions that, once finalized, will provide favorable changes for plan sponsors and participants. The regulations respond to statutory changes made by the Tax Cuts and Jobs Act of 2017 (the "2017 Tax Act") and other legislation. The proposed regulations also provide helpful clarifications that the IRS had been considering for some time.

Assuming these regulations are finalized as proposed, most employers with individually-designed plan documents will need to make appropriate amendments to their 401(k) plan provisions by no later December 31, 2021, although this date is not yet certain. Plan sponsors may implement the proposed regulations in plan years generally beginning after December 31, 2018, and must comply with certain requirements for distributions made on or after January 1, 2020.

Background

Generally, 401(k) plans may permit an in-service distribution of employee deferrals on account of a hardship, only if the distribution meets two requirements (based on all of the relevant facts and circumstances):

1. the distribution is made on account of an immediate and heavy financial need; and
2. the amount of the distribution is not in excess of the amount necessary to satisfy that need.

For administrative ease, IRS regulations also provide for a safe harbor under which distributions for certain specified expenses are automatically deemed to be made on account of an immediate and heavy financial need. Additionally, IRS regulations offer a safe harbor for determining that a distribution is deemed necessary to satisfy such need.

Revisions to the Safe Harbor List of Expenses

The proposed regulations modify the safe harbor list of hardship distribution expenses by incorporating previously issued IRS guidance, clarifying changes to hardship distribution rules from the 2017 Tax Act, and expanding available safe harbor expenses. Employers may apply these rules to distributions made beginning as early as January 1, 2018.

1. The proposed regulations incorporate prior IRS guidance which permits an employee to use hardship distributions to pay for certain expenses that are not his or her own. Specifically, an employee can pay qualifying medical, tuition, and funeral expenses for his or her beneficiary under the plan.
2. The proposed regulations eliminate the need to make a showing of a federally-declared disaster to qualify for a hardship distribution to pay for the expense of repairing damage to the employee's home if the damage otherwise qualifies for a casualty loss deduction under Code Section 165.
3. The proposed regulations add a new safe harbor expense for an employee's expenses and losses (including a loss of income) incurred on account of a federally-declared disaster, as long as the employee's home or principal place of business at the time of the disaster was located in the federally-designated disaster area.

New Test for Determining the Necessity of a Hardship Distribution

The proposed regulations replace the existing rules for determining whether a hardship distribution is necessary to satisfy the immediate and heavy financial need with one general three-part test:

1. the hardship distribution may not exceed the amount of an employee's need (including amounts necessary to pay applicable taxes and penalties reasonably anticipated to result from the distribution);
2. the employee must have obtained other available distributions under the employer's qualified and nonqualified deferred compensation plans; and
3. the employee must represent in writing or electronically that he or she has insufficient cash or other liquid assets to satisfy the financial need. The plan administrator may rely on the employee's representations, so long as the plan administrator doesn't have actual knowledge to the contrary.

Notably, this proposed test drops two requirements from the existing test, specifically:

1. The suspension of employee deferrals for six months after a hardship distribution. In other words, an employee will no longer be penalized for taking a hardship distribution by having his or her deferrals under the employer's plan suspended for a six-month period. Employers can choose to eliminate the deferral suspension for hardship distributions made in mid-2018, where the deferral suspension would otherwise have extended into 2019.
2. The prerequisite that the employee obtain all nontaxable plan loans available under the employer's plans before taking a hardship distribution.

Generally, plans may impose additional conditions to demonstrate that a distribution is necessary to satisfy an immediate and heavy financial need. For instance, under the proposed regulations, employers retain the discretion to require plan loans before permitting an employer to take a hardship distribution. However, the deferral suspension requirement on hardship distributions made on or after January 1, 2020 is banned outright.

Hardship Distributions Can Be Made from More Sources

Previously-restricted sources of contributions will be available for hardship distributions, but employers continue to have discretion in limiting the sources they want to make available for hardship distributions. Available sources now also include:

1. qualified nonelective contributions,
2. qualified matching contributions,
3. safe harbor contributions (including earnings on such sources), and
4. earnings on elective deferrals.