When workers experience a financial hardship, sometimes their retirement plan is the only financial resource they can tap into. The tax laws for qualified retirement plans, like 401(k) plans, permit plan sponsors to grant hardship distributions to workers if the requirements listed in Treasury regulations and the plan documents are met.
Most 401(k) plans permit hardship distributions, but the rules are changing. This article provides a review of the existing rules and the time line for recent law and regulatory changes for hardship distributions of 401(k) plan elective deferrals. Plan sponsors may want to consider whether they want to incorporate any of the optional changes and evaluate how the mandatory changes will affect plan operations.
General Hardship Distribution Rules
To qualify for a hardship distribution of their 401(k) plan elective deferrals, a participant must experience an “immediate and heavy financial need” and demonstrate that the hardship distribution is necessary to satisfy the financial need.
Many plans adopt the regulatory safe harbor rules for hardship distributions, which provide six types of expenses that are deemed to meet the immediate and heavy financial need requirement:
- Medical care expenses incurred by the participant, the participant’s spouse or dependents
- Costs directly related to the purchase of the participant’s principal residence
- Payment of tuition, fees, and room and board expenses for post-secondary education for the participant, the participant’s spouse or dependents
- Payments necessary to prevent the mortgage foreclosure or eviction from the participant’s principal residence
- Funeral expenses for the participant’s deceased parent, spouse or dependents
- Certain expenses relating to the repair of damage to the participant’s principal residence
A hardship distribution is considered to be necessary to satisfy the financial need if:
- The amount distributed doesn’t exceed the amount of the need, including amounts to pay any taxes or penalties as a result of the distribution.
- The participant has obtained all other plan distributions and loans available.
- The participant isn’t allowed to make elective deferrals to the plan for six months after the hardship distribution.
Changes to Hardship Distribution Rules
The Bipartisan Budget Act of 2018 made law changes that make it easier for a participant to take a hardship distribution, which ultimately may reduce the administrative burden on plan sponsors. In November 2018, the Treasury Department proposed regulatory changes to help plan sponsors implement the law changes and to make a few additional changes. The combination of the law changes and proposed regulatory changes result in various effective dates.
For hardship distributions made on or after January 1, 2018:
- The participant’s primary beneficiary under the plan is added to the list of individuals for whom medical, educational and funeral expenses may qualify for a hardship. (This was added by the Pension Protection Act of 2006 but is just now being incorporated into the Treasury regulations.)
- Expenses related to a FEMA-declared disaster qualify as a deemed immediate and heavy financial need.
For plan years beginning on or after January 1, 2019:
- Plan sponsors may choose to allow qualified nonelective contributions, qualified matching contributions, safe harbor 401(k) contributions, and investment earnings to be accessed for hardship distributions, in addition to 401(k) plan elective deferrals.
- Plan sponsors may choose to a) require participants to take all available plan loans before granting a hardship distribution or b) eliminate this requirement.
- Plan sponsors may choose to a) require participants to suspend elective deferrals for six months following a hardship distribution or b) eliminate the six-month suspension of deferrals.
For hardship distributions made on or after January 1, 2020:
- The six-month suspension of elective deferrals following a hardship distribution is no longer allowed.
- Plan sponsors must follow a general standard for determining whether the hardship distribution is necessary to satisfy the financial need.
- The hardship may not exceed the amount of need, plus taxes and penalties.
2. The participant must have obtained all other plan distributions available (other than loans, unless required by the plan sponsor).
3. The participant must represent in writing that they don’t have the cash or liquid assets to satisfy their financial need. The plan administrator can rely on the participant’s representation so long as they don’t have actual knowledge to the contrary.
The IRS acknowledges that a plan amendment will be necessary to reflect the hardship rule changes, but an interim amendment for pre-approved plans will not be required until final regulations are issued (likely later this year).
In the meantime, plan sponsors can work with their plan advisor and TPA/recordkeeper to complete the following tasks related to the recent rule changes for hardship distributions:
- Review the plan document to understand the plan’s existing hardship distribution policies
- Understand the options available and document any necessary elections for the 2019 plan year