The IRS has issued proposed regulations affecting hardship distributions under 401(k) plans. The regulations would implement changes made by the Bipartisan Budget Act of 2018, and are updated for several earlier legislative changes to Section 401(k) of the Internal Revenue Code of 1986 (“Code”).
Bipartisan Budget Act. The proposed regulations implement the following changes made by the Bipartisan Budget Act effective for plan years beginning after December 31, 2018:
- Allow a hardship distribution to be taken from qualified non-elective contributions, qualified matching contributions, employer “safe harbor” contributions and earnings on elective deferrals;
- No longer require a participant to take a plan loan before taking a hardship withdrawal; and
- No longer require that elective deferrals be suspended for six months following a hardship withdrawal. Plan sponsors may apply this rule as of the first day of the plan year after December 31, 2018 even if the hardship withdrawal was taken in a prior plan year. For example, a calendar year plan may be amended to provide that a participant who received a hardship distribution in the second half of the 2018 plan year will be prohibited from making elective deferrals only until January 1, 2019. Lifting the suspension rule is not required. A plan sponsor may continue to suspend contributions for the originally scheduled six months.
“Safe Harbor” Distribution Events. A distribution is deemed to be on account of an immediate and heavy financial need if it is for one of six “safe harbor” events: (1) medical expenses; (2) purchase of a principal residence; (3) payment of college tuition and fees; (4) payments to prevent eviction from, or foreclosure on, a principal residence; (5) funeral expenses; and (6) casualty losses.
The “safe harbor” hardship distribution events were modified to:
- Provide that a casualty loss will qualify for a hardship distribution even if it does not satisfy the standards for deductibility under the Code. For taxable years 2018-2025, a casualty loss is deductible only if it is attributable to a federally declared disaster.
- Add a seventh “safe harbor” distribution event: expenses incurred by the participant in a federally declared disaster, if the participant’s principal residence or primary place of employment is located in the disaster area.
The proposed regulations also updated the “safe harbor” hardship distribution events to provide that a hardship distribution may be made for medical expenses, tuition expenses or funeral expenses of a primary beneficiary, consistent with the Pension Protection Act of 2006.
“General” Test for Whether a Financial Hardship Exists. As an alternative to the safe harbor test, a plan can assess whether a hardship exists based on all of the relevant facts and circumstances. The proposed regulations would modify the “general” standards applicable to a hardship distribution to delete the facts and circumstances test and substitute the following:
- The hardship distribution may not exceed the amount of a participant’s need (including any amounts necessary to pay income taxes on the distribution);
- The participant must have obtained all other available distributions from the plan and all other deferred compensation plans (qualified or non-qualified) of the employer; and
- For a distribution made on or after January 1, 2020, the participant must represent (in writing, which may include electronic means) that he or she has insufficient cash or other liquid assets to satisfy the financial need.
A plan may apply other conditions to the “general” hardship standards, but may not make suspension of elective deferrals a condition on or after January 1, 2020.
Plan Amendments. After the regulations are finalized, plans must be amended by the end of the second calendar year after the year in which the final regulations are included on the IRS Required Amendments List. Even though plans may not need to be formally amended in 2018, a plan sponsor should discuss the changes to the hardship distribution rules with its record-keeper and understand how they will be implemented as soon as January 1, 2019, and consider appropriate communications to participants.
Tax Rules. Even though some of the restrictions on hardship distribution are eased, participants should keep in mind that hardship distributions will be taxable income to the participant, subject to a 10% early distributions tax if the participant is not age 59½ or older.
If you have any questions, please contact Cynthia A. Moore at (248) 433-7295, or any other member of Dickinson Wright’s Employee Benefits and Executive Compensation team.