The Internal Revenue Service (IRS) issued final regulations effective September 23, 2019 (84 Federal Register 49651), to reflect several legislative changes, including changes made by the Bipartisan Budget Act of 2018 pertaining to hardship distributions from 401(k) plans. Under Treas. Reg. §1.401(k)-1(d)(3), a distribution is made to an employee on account of hardship only for an immediate and heavy financial need. In addition, the amount of the distribution can’t exceed the amount necessary to satisfy that need, but it can include amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution. Thus, a hardship distribution amount is included in gross income for the taxable year when the distribution is received.
A SIMPLIFIED PROCESS
The previous rules required that all relevant facts and circumstances be considered when determining if a distribution is necessary to satisfy a financial need. This could lead to uncertainty for plan administrators, taxpayers, and the IRS. So the new regulations instead provide a general standard for determining whether a distribution is necessary. A hardship distribution can be made as long as:
- The distribution isn’t greater than the 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- The employee has withdrawn all other available (nonhardship-related) distributions, including from the 401(k) plan as well as from all other plans of deferred compensation whether qualified or not under the employer’s plans; and
- The employee has provided a written representation—which could include the use of an “electronic medium” as defined in Treas. Reg. §1.401(a)-21(e)(3)—that he or she has insufficient cash or other liquid assets available to satisfy the financial need. Yet a hardship distribution may not be made if the plan administrator has actual knowledge that’s contrary to the representation. (In regard to using an electronic medium, the preamble of the final regulations provides clarification that verbal representation via telephone is acceptable if the call is recorded and maintained.)
Although the new general rules provide some administrative simplicity, that last provision is somewhat interesting. There are cases where a taxpayer requests an offer in compromise that’s rejected because the taxpayer has the means to pay the tax liability in whole. (An offer in compromise is an IRS program that allows taxpayers to negotiate a settlement to reduce an unpaid tax debt.) If taxpayers believe they can make a low-ball offer in compromise, why wouldn’t employees be willing to claim hardship when other assets are actually available? The IRS can say no to an offer in compromise. The plan administrator, on the other hand, should disapprove the distribution only if he or she has actual knowledge.
The administration of this process may have been simplified by removing the need to examine all the relevant facts and circumstances to determine whether a distribution is needed, but, as two commenters to the proposed regulations noted, this may make the plan administrator’s role irrelevant. The preamble to the final regulations states that this requirement doesn’t impose an obligation on plan administrators to investigate the employee’s financial condition. Instead this rule is limited to situations where the plan administrator already has sufficiently accurate information to determine the accuracy of the employee’s representation. The U.S. Department of the Treasury and the IRS believe that the new requirement helps ensure the integrity of the procedure to determine the employee’s financial need.
Treas. Reg. 1.401(k)-1(d)(3)(ii)(B) provides a revised list of seven safe harbor expenses that qualify as immediate and heavy financial need. Under the final regulations, three modifications are made to the qualifying items included in the list.
The first modification added the primary beneficiary as an individual for whom qualified medical, educational, and funeral expenses may be incurred. Specifically, this modification was added to expenses pertaining to medical expense without regard to the adjusted gross income limitation and the recipients of the medical care (the first safe harbor expense); the payment of tuition and related educational and living expenses for up to 12 months of post-secondary education of the employee or for the employee’s spouse, child, or dependent (third expense); and burial or funeral expenses for the deceased parent, spouse, child, or dependent (fifth expense).
The second modification expanded the sixth safe harbor expense item to include expenses qualifying as a casualty loss for the repair of damage to the employee’s principal residence without regard to the casualty loss deduction limitation attributable to a federally declared disaster and the adjusted gross income limitation.
Finally, the seventh safe harbor expense was added. It includes expenses and losses (including loss of income) incurred by the employee on account of a disaster declared by the Federal Emergency Management Agency (FEMA) under the Robert T. Stafford Disaster Relief and Emergency Assistance Act, Public Law 100-707, provided that the employee’s principal residence or principal place of employment at the time of the disaster was located in an area designated by FEMA for individual assistance with respect to the disaster.
Although some commenters to the proposed regulations questioned this limitation of the hardship to the employee only and not to the employee’s relatives and dependents (as under the disaster-relief announcements), Treasury and the IRS concluded that limiting distributions to only the employee is consistent with the purpose of the hardship provision.
The final regulations also modified the distribution rules necessary for satisfying the financial need. The employee and employer are no longer prohibited from making contributions to the employee’s 401(k) plan for six months after taking a hardship distribution. Also, the employee is no longer required to take plan loans prior to obtaining a hardship distribution.
In addition, the sources of funds available to an employee for the hardship distribution are expanded. Specifically, the hardship distribution can include amounts that are elective contributions, qualified nonelective contributions, qualified matching contributions, and earnings on these amounts regardless of when contributed or earned.
An employee considering a hardship distribution should be made aware that there may be an alternative to take a plan loan (if permitted by the 401(k) plan). The employee can replenish his or her 401(k) plan by repaying the loan. This opportunity isn’t available for amounts removed as a hardship distribution.
Another important distinction between the alternatives is the fact that borrowing from a 401(k) plan (if permitted) isn’t included in the employee’s gross income; whereas, the amount taken as a hardship distribution is. Thus, an employee must withdraw a greater amount as a hardship distribution to pay the taxes associated with the distribution in order to have an adequate amount to satisfy the hardship.
© 2020 A.P. Curatola