By Joe Bishop
Those who participate in 401(k) plans and come upon an immediate and heavy financial need have the option of taking a special kind of distribution from their retirement account. Distributions of this nature are called “hardship distributions”, and as you might imagine, they are subject to several rules and restrictions by the IRS. These rules have remained fairly consistent for the past several years, but changes will soon be coming that must be considered by organizations that sponsor retirement plans for their employees.
Before we get into the specific changes, what follows is a general overview of the long-standing policies that have been in place. First, it should be noted that hardship distributions can only be taken for the following reasons (which together constitute the “safe harbor definition” for hardship distributions):
- Medical expenses of the employee, as well as his or her spouse, dependents or primary beneficiary
- Costs related to the purchase of an employee’s primary residence
- Tuition and related educational fees and expenses covering the next 12 months of postsecondary education for the employee, as well as his or her spouse, dependents or primary beneficiary
- Payments necessary to prevent eviction from, or foreclosure on, the employee’s primary residence
- Burial and/or funeral expenses for the employee, as well as his or her spouse, children, dependents or primary beneficiary
- Certain expenses to repair damage to the employee’s primary residence
Plan sponsors, with the assistance of their third-party administrators (TPAs), should always work to obtain documentation from employees supporting their financial need. The Plan sponsor should maintain this documentation on file at all times.
Additionally, the IRS had also imposed the following rules and restrictions on hardship distributions, among others:
- Hardship distributions cannot exceed the amount necessary to cover the employee’s financial need
- Before taking out a hardship distribution, the employee must have already taken out all available loans from the plan
- After taking out a hardship distribution, the employee’s deferrals into the plan must be suspended for six months
- Hardship distributions can generally only be taken from employee deferrals, employer matching contributions, and employer profit-sharing contributions
With the passing of the Bipartisan Budget Act of 2018, three major changes are in store that will affect the approval and processing of hardship distributions. The changes will allow employees who suffer financial difficulties to more easily obtain assistance from their retirement accounts. The IRS provides 401(k) plans with the option of implementing the changes for plan years beginning in 2019. However, for plan years beginning in 2020 (when the proposed regulations are set to become final), plans will likely be required to do so.
The three major changes are as follows:
- Employees will no longer be required to take out a loan from their retirement accounts prior to taking out a hardship distribution
- The six-month suspension of employee deferrals following a hardship distribution will no longer be allowed; however, employees may still elect to opt out of deferrals in accordance with other Plan provisions
- Amounts previously contributed as qualified non-elective or qualified matching contributions (QNECs/QMACs) may be made available for hardship distributions
When a plan adopts the above changes, the plan sponsor will have to work with its TPA to draft amendments to the Plan Document detailing each of the resulting policy changes. It is imperative that the terms of plan documents, adoption agreements, and summary plan descriptions remain consistent with management’s policies at all times.
Please note that the impending changes only apply to plans that use the safe harbor definition for hardship distributions, as described above. Also, organizations that manage 403(b) arrangements should be aware that they will be subject to most of the changes as well.
The Budget Act includes several other provisions beyond the scope of this article that may have an impact on your retirement plan. If you have any questions or concerns, or if you would like more details regarding the changes to hardship distribution rules, please do not hesitate to contact us.