In recent months, the IRS has provided guidance with respect to hardship withdrawals from tax-qualified plans. In an October 2016 entry on its website, Hardship Distribution Tips from EP Exams, the IRS advised plan sponsors that a common operational error in connection with hardship distributions is permitting participants to take hardship withdrawals when the plan does not specifically provide for them. The IRS reminded plan sponsors that, even though the law permits a hardship withdrawal for specified purposes, such as burial or funeral expenses, a plan cannot make a distribution on account of a hardship unless the plan specifically so provides. That guidance also included a warning to plan sponsors with respect to electronic hardship applications. The potential problem here is that, even though plan participants would be self-certifying that they satisfy the hardship withdrawal criteria, the plan sponsor is still responsible for verifying that the hardship withdrawal requirements have been satisfied and for retaining records relating to hardship distributions.
In a January 2017 entry on its website, the IRS reminded plan sponsors that it is up to them to track loans and hardship distributions, and stated that "electronic self-certification is not sufficient documentation of the nature of an employee's hardship." In the IRS's interpretation of the relevant regulations, while self-certification is permitted to show that a distribution is the sole way to relieve a hardship, self-certification is not allowed to show the nature of the hardship. The January guidance requires plan sponsors to obtain and keep hardship distribution records. According to the IRS, it is insufficient as a means of satisfying the record- keeping requirements for participants to keep their own records of hardship distributions. The IRS's concern is that participants may terminate employment or fail to keep copies of hardship documentation, thus making their records inaccessible during an IRS audit of the plan.
Most recently, on February 23, 2017, the IRS issued a memorandum to Employee Plans Examination Employees regarding Substantiation Guidelines for Safe-Harbor Hardship Distributions from 401(k) Plans. Although a 401(k) plan sponsor that wishes to offer hardship withdrawals as an optional feature under its plan may select non safe-harbor, safe-harbor or a combination of both, the most commonly selected alternative is the safe harbor option. The 401(k) regulations identify six categories of safe-harbor distribution:
- Expenses for medical care that would be deductible under the Internal Revenue Code for the employee, or the employee's spouse, child, dependent or primary beneficiary under the plan;
- Costs directly related to the purchase of a principal residence;
- Payment of tuition-related educational fees, room and board for up to the next 12 months of post-secondary education for the employee, or the employee's spouse, child, dependent or primary beneficiary under the plan;
- Payments necessary to prevent the eviction of the employee from the employee's principal residence or foreclosure on the mortgage on that residence;
- Payments for burial or funeral expenses for the employee's deceased parent, spouse, child, dependent or primary beneficiary under the plan; and
- Expenses for the repair of damages to the employee's principal residence that would qualify for the casualty deduction under Code Section 165.
The Substantiation Guidelines take a different view of participant involvement in documentation from the guidance on the IRS website. The Guidelines indicate that if the employer or administrator received a summary of source documents such as contracts, bills or foreclosure notices, rather than the source documents themselves, the IRS examining agent should inquire whether the employer or TPA had provided a specified notification to the participant prior to making the hardship distribution. Three of the four items on that notice are tax-related items: (i) the hardship distribution is taxable and additional taxes could apply; (ii) the amount of the distribution cannot exceed the immediate and heavy financial need; and (iii) hardship distributions cannot be made from earnings on elective contributions or from qualified nonelective contributions or qualified matching contributions, if applicable. The fourth item requires the participant's agreement to preserve source documents and make them available on request to the employer or administrator, without specifying the consequences of the participant's failure to comply with his or her agreement.
The Guidelines also indicate the IRS agent should be concerned if there have been multiple hardship distributions in the same plan year, while recognizing these could be entirely permissible, such as quarterly payments of tuition or follow-up medical or funeral expenses. Finally, if an administrator is receiving summary information rather than source information from participants, the IRS examining agent must determine whether the administrator provides a report to the employer, at least annually, describing the hardship distributions made during the plan year.
Forewarned is forearmed, and in light of this recent series of guidance with respect to possible errors in administering hardship withdrawals, plan sponsors should examine their plan's operation to determine if changes may be required.