On November 9, 2018, the US Department of the Treasury and the Internal Revenue Service (IRS) issued proposed regulations addressing statutory changes to the section 401(k) hardship distribution rules, including changes made earlier this year by the Bipartisan Budget Act of 2018 (the Budget Act). The proposed regulations provide direction on a number of key issues:

• Starting no later than January 1, 2020, plans must eliminate the six-month suspension on participant contributions following a hardship distribution.
• The safe harbor for hardship withdrawals following casualty losses can continue to be applied without regard to the new limitations on the casualty loss deduction made by the Tax Cuts and Jobs Act (the TCJA).
• Plans may elect to continue excluding earnings from the amounts available for hardship distributions and to require all available non-taxable plan loans be taken before receiving a hardship distribution.
• Section 403(b) plans may not permit hardship distributions of earnings on elective deferrals.
• No immediate plan amendments are necessary as a result of the proposed regulations, though plan sponsors may wish to do so for clarity and to avoid subsequent disputes.

Background
Generally, elective deferrals made to a section 401(k) plan may not be distributed before an active participant reaches age 59-1/2, subject to limited exceptions. Hardship distributions—distributions made to satisfy an immediate and heavy financial need—are one such exception. The hardship distribution rules were explicitly modified by the Budget Act, effective for plan years starting on or after January 1, 2019, and other recent legislation has affected the rules.

The current hardship distribution rules operate as follows:

• Hardship distributions are allowed only upon a participant’s immediate and heavy financial need.
• The amount of a hardship distribution must not be in excess of the amount necessary to satisfy that need. If a plan sponsor so chooses, this can be satisfied through reliance on a safe harbor that specifies six events that will be deemed an immediate and heavy financial need, such as certain medical expenses not covered by insurance.
• The amount of the distribution must not be in excess of the amount necessary to satisfy that need. This is deemed satisfied if the participant (1) takes all available distributions and non-taxable loans under the employer’s retirement plans, and (2) the employer imposes a six-month suspension on the participant’s employee contributions.
• Distributions are limited to the participant’s elective deferrals, excluding earnings.
• Similar rules apply to section 403(b) plans.

Recent legislation, including the Budget Act, made the following changes:

• The Budget Act permits hardship distributions to be made from earnings on elective deferrals, as well as from qualified non-elective contributions (QNECs), qualified matching contributions (QMACs) and earnings on QNECs and QMACs.
• The Budget Act eliminates the safe harbor requirements to (1) suspend elective deferrals for six months after a hardship distribution, and (2) require that participants exhaust all available non-taxable plan loans before receiving a hardship distribution.
• The TCJA narrowed the safe harbor events by limiting casualty loss deductions to losses incurred in federally declared disaster areas.
• The Pension Protection Act of 2006 permits plans to treat a participant’s beneficiary the same as a spouse or dependent in determining whether the participant has incurred a hardship.

Proposed Regulations
In response to these statutory changes, the proposed regulations would make a number of changes to the current regulations.

The proposed regulations modify the safe harbor list of eligible expenses:

• A casualty loss is determined without regard to the changes made by the TCJA, limiting the deductions to losses in federally declared disaster areas. This clarification allows the safe harbor for casualty losses to continue to operate as it always has.
• A seventh safe harbor is added for expenses incurred following a federally declared disaster. This change may help mitigate the need for special IRS guidance following each disaster and speed up the availability of distributions.
• The medical, educational or funeral expenses of a participant’s primary beneficiary under the plan constitute a permissible expense. (This change has already been in effect since 2006 but will now be reflected in the proposed regulations.)

The proposed regulations eliminate the safe harbor requirements to take all available plan loans prior to, and to suspend contributions for six months following, a hardship distribution. In addition, a plan may permit hardship distributions from earnings, QNECs, QMACs and safe harbor contributions.

The proposed regulations make a number of clarifications with respect to section 403(b) plans:

• The same expanded safe harbor list of “immediate and heavy need” conditions that apply to section 401(k) plans are generally applicable to section 403(b) plans.
• Earnings on 403(b) elective deferral contributions remain ineligible for hardship distribution (because the statutory provision prohibiting such distributions was not amended).
• QNECs and QMACs remain ineligible for hardship distributions from section 403(b) plans that are custodial accounts (because the statutory provision prohibiting such distributions was not amended).

The IRS also has proposed making it easier for plan administrators to satisfy the immediate and heavy financial need. A plan administrator need only: (i) limit the amount of the distribution to the employee’s need (including taxes on the distribution), (ii) ensure the participant has taken all available plan distributions (other than loans), and (iii) obtain a representation from the participant that he or she does not have the necessary cash or liquid assets available to satisfy the need (and the plan administrator does not have actual knowledge that the participant has sufficient cash or liquid assets). Notably, the representation is a new requirement (though it was already included in many recordkeeping hardship distribution processes), and will be mandatory for all hardship withdrawals beginning January 1, 2020.

Importantly, the proposed regulations provide that plans may continue to impose stricter requirements on demonstrating immediate and heavy financial need, such as requiring that all plan loans be taken before making a hardship withdrawal. Plans may also continue to prohibit hardship withdrawals from earnings, QNECs and QMACs. However, for hardship withdrawals on or after January 1, 2020, plans (i) may not impose a six-month suspension on contributions following a hardship distribution, and (ii) must obtain a representation from the participant that he or she does not have the necessary cash or liquid assets available to satisfy the hardship.

Effective Date and Plan Amendments
The proposed regulations generally would become effective for plan years beginning on or after January 1, 2019, the same effective date as the statutory changes made by the Budget Act. However, the proposed regulations make the following clarifications to the effective date:

• Any “in-progress” six-month contribution suspension may be ended on the effective date of the new rules (i.e., for a calendar year plan, all in-progress six-month suspensions may be ended January 1, 2019).
• The changes related to safe harbor distributions with respect to casualty losses and federally declared disaster areas may be applied starting January 1, 2018.

Amendments must be completed by the end of the second calendar year that begins after issuance by the IRS of the Required Amendments List (per Rev. Proc. 2016-37) that includes the change.

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