Final Regs Modify Qualifications for a 401(k) Hardship Distribution

(Parker Tax Publishing September 2019)

The IRS issued final regulations that amend the rules relating to hardship distributions from Code Sec. 401(k) plans, as well as other rules relating to Code Sec. 401. The final regulations reflect statutory changes affecting Code Sec. 401(k) plans, including changes made by the Bipartisan Budget Act of 2018, and affect participants in, beneficiaries of, employers maintaining, and administrators of plans that include cash or deferred arrangements or provide for employee or matching contributions. T.D. 9875.

Background

Under Code Sec. 401(k)(1), a profit-sharing, stock bonus, pre-ERISA money purchase, or rural cooperative plan will not fail to qualify under Code Sec. 401(a) merely because it includes a cash or deferred arrangement (CODA) that is a qualified CODA. Under Code Sec. 401(k)(2), a CODA (generally, an arrangement providing for an election by an employee between contributions to a plan or payments directly in cash) is a qualified CODA only if it satisfies certain requirements. Code Sec. 401(k)(2)(B) provides that contributions made pursuant to a qualified CODA (i.e., elective contributions) may be distributed only on or after the occurrence of certain events, including death, disability, severance from employment, termination of the plan, attainment of age 59 1/2, hardship, or, in the case of a qualified reservist distribution, the date a reservist is called to active duty. Code Sec. 401(k)(2)(C) requires that elective contributions be nonforfeitable at all times.

On September 23, the IRS issued final regulations in T.D. 9875, which update the hardship distribution rules for Code Sec. 401(k) plans (401(k) plans). The final regulations also update the Code Sec. 401 rules relating to the actual deferral percentage test in Code Sec. 401(k)(3) and the actual contribution percentage test in Code Sec. 401(m)(2). The final regulations are substantially similar to the previously issued proposed regulations (REG-107813-18), and plans that complied with the proposed regulations will satisfy the final regulations.

Deemed Immediate and Heavy Financial Need

The final regulations, like the proposed regulations, modify the safe harbor list of expenses in existing Reg. Sec.1.401(k)-1(d)(3)(iii)(B) for which distributions are deemed to be made on account of an immediate and heavy financial need by: (1) adding "primary beneficiary under the plan" as an individual for whom qualifying medical, educational, and funeral expenses may be incurred; (2) modifying the expense listed in existing Reg. Sec.1.401(k)-1(d)(3)(iii)(B)(6) (relating to damage to a principal residence that would qualify for a casualty deduction under Code Sec. 165) to provide that for this purpose the limitations in Code Sec. 165(h)(5) (added by TCJA) do not apply; and (3) adding a new type of expense to the list, relating to expenses incurred as a result of certain disasters.

Practitioners had observed that this new safe harbor expense, which was described in the preamble to the proposed regulations as similar to relief provided by the IRS after certain major federally declared disasters, was narrower in certain respects than the past IRS relief and asked for confirmation that the narrowing was intentional. Some practitioners also raised the concern that the new safe harbor expense would lead the IRS to discontinue its practice of issuing announcements providing such relief.

In the preamble to the final regulations, the IRS responded that the effect of the new safe harbor expense differs from the disaster-relief announcements in three main respects. First, only disaster-related expenses and losses of an employee who lived or worked in the disaster area will qualify for the new safe harbor expense, and not, as under the disaster-relief announcements, expenses and losses of the employee's relatives and dependents. The IRS concluded that limiting distributions only to those employees directly affected by a disaster was consistent with the purposes underlying the Code's hardship distribution provisions and better aligns with the relief given to affected individuals under Code Sec. 7508A for similar disasters.

Second, the IRS said, unlike under the disaster-relief announcements, there is no specific deadline by which a request for a disaster-related hardship distribution must be made and no specific authority to relax certain procedural requirements established by the plan administrator or plan terms (although the IRS expects that plan administrators will be flexible in interpreting plan terms requiring documentation relating to the hardship when processing hardship distribution requests during the difficult circumstances following a disaster).

Third, the IRS noted, unlike under the disaster-relief announcements, there is no extended deadline for plan sponsors to add disaster-related distribution or loan provisions to the plan. In the absence of such an extended deadline, a plan sponsor that does not choose to add disaster-related hardship distribution provisions as part of an amendment reflecting the final regulations but instead chooses to wait until a disaster occurs to add those provisions (or to add a loan provision) would need to adopt a plan amendment by the end of the plan year the amendment is first effective.

According to the IRS, making expenses related to certain disasters a safe harbor expense is intended to eliminate any delay or uncertainty concerning access to plan funds that might otherwise occur following a major disaster. Thus, the IRS expects that no more disaster-relief announcements will be needed.

Distribution Necessary to Satisfy Financial Need

The final regulations, like the proposed regulations, modify the rules for determining whether a distribution is necessary to satisfy an immediate and heavy financial need by eliminating (1) any requirement that an employee be prohibited from making elective contributions and employee contributions after receipt of a hardship distribution, and (2) any requirement to take plan loans before obtaining a hardship distribution. In particular, the final regulations eliminate the safe harbor in existing Reg. Sec.1.401(k)-1(d)(3)(iv)(E), under which a distribution is deemed necessary to satisfy the financial need only if elective contributions and employee contributions are suspended for at least six months after a hardship distribution is made and, if available, nontaxable plan loans are taken before the hardship distribution is made.

The final regulations, like the proposed regulations, eliminate the existing rule under which the determination of whether a distribution is necessary to satisfy a financial need is based on all the relevant facts and circumstances and provide one general standard for determining whether a distribution is necessary. Under this general standard, a hardship distribution may not exceed the amount of an employee's need (including any amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution), the employee must have obtained other available, non-hardship distributions under the employer's plans, and the employee must provide a representation that he or she has insufficient cash or other liquid assets available to satisfy the financial need. A hardship distribution may not be made if the plan administrator has actual knowledge that is contrary to the representation.

Expanded Sources for Hardship Distributions

The final regulations, like the proposed regulations, modify existing Reg. Sec.1.401(k)-1(d)(3) to permit hardship distributions from 401(k) plans of elective contributions, qualified nonelective contributions (QNECs), qualified matching contributions (QMACs), and earnings on these amounts, regardless of when contributed or earned.

Section 403(b) Plans

Reg. Sec. 1.403(b)-6(d)(2) provides that a hardship distribution of Code Sec. 403(b) elective deferrals is subject to the rules and restrictions set forth in Reg. Sec. 1.401(k)-1(d)(3). Accordingly, the new rules relating to a hardship distribution of elective contributions from a 401(k) plan generally apply to Code Sec. 403(b) plans. The final regulations also provide that QNECs and QMACs in a Code Sec. 403(b) plan that are not in a custodial account may be distributed on account of hardship, but QNECs and QMACs in a Code Sec. 403(b) plan that are in a custodial account continue to be ineligible for distribution on account of hardship.

For a discussion of the requirements for a hardship distribution, see Parker Tax ¶131,125.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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