The IRS has updated its hardship distribution rules for 401(k) and tax sheltered annuity 403(b) plans. The new rules add a disaster expense safe harbor. They also make it easier for employers to determine whether an employee qualifies for a distribution.
Under the changes, plans may:
- distribute employer contributions and investment earnings as well as employee contributions to 401(k) participants;
- adopt an additional safe harbor category for FEMA declared disaster expenses and losses; and
- adopt streamlined procedures that make some existing required conditions optional.
Expanded Sources for Hardship Distributions
Historically, plans could only pay out employee contributions, not earnings or employer contributions. Thanks to changes in the Tax Cuts and Jobs Act, 401(k) plans are free to distribute employer contributions and earnings. Employer contributions include matching and nonelective safe harbor contributions.
Comment: 401(k) plans are not required to make this change and must be amended to do so. TSA 403(b) plans must stick with the old contributions-only limit.
Changes to Conditions Plans Must Impose
Under prior rules, the necessary conditions for a hardship distributions were:
- the employee had no alternative means or resources available to satisfy the need based on the facts and circumstances;
- the employer did not have actual knowledge that the need can be relieved through insurance, borrowing, selling assets, ceasing deferrals, or taking other plan distributions; and
- the employee first obtained all available non-hardship plan distributions including ESOP distributions and plan loans, and
- the employee cannot contribute for at least 6 months after receipt of the distribution.
Revised Necessary Conditions
The main change is that the prohibition by the employer on future employee contributions is not only not required it is prohibited.
Another major change is that an employer is no longer required to condition a hardship distribution on the employee first taking all plan loans.
The necessary conditions for a hardship distribution under the new rules are:
- the distribution cannot exceed the need (including taxes and penalties caused by the distribution); and
- the employee has taken all other available nonhardship distributions under any of the employer’s plans including ESOP dividends, and represents that the employee has insufficient cash or other liquid assets to satisfy the financial need.
The employer may rely on the facts as the employee represents them unless is has actual knowledge to the contrary.
Under the new rules, an employer are free to keep or adopt rules similar to some of those required under the old rules, with some adjustments.
First, the employer may impose a facts and circumstances test that takes into account assets owned by the employee’s spouse or minor children. For example, a vacation home owned with the employee’s spouse would need to be sold first. However, assets in an irrevocable trust made under the Uniform Gifts to Minors Act could not be counted for this purpose.
Second, an employer may require that an employee first obtain all nontaxable plan loans, as well as require the employee first take any insurance or other reimbursement, liquidate assets, and borrow from commercial sources.
Comment: These sorts of optional requirements would impose a burden on the plan in processing distribution requests. However, most employers have no obvious economic reason to care if the employee takes a distribution from the employee’s 401(k). So the slimmed down approach would make sense for many employers.
Safe Harbor Hardship Expense Categories
The IRS has six categories of financial needs in its existing rules for which an employee can be deemed to qualify for a hardship distribution. The existing expense categories include:
- medical expenses for the employee, spouse, or dependent that would qualify as deductible (even if not actually deducted due to the AGI floor);
- costs for a home purchase;
- college expenses for the next 12 months for employee, spouse, children or dependents;
- payments to avoid eviction or foreclosure;
- burial or funeral expenses for the employee or deceased parent, spouse, child or dependent; and
- expenses to repair a principal residence that would qualify for a casualty loss deduction (even if not actually deducted due to the AGI floor).
Changes to Safe Harbor Expense Categories
The new rules make the following changes.
Medical, College, Funeral and Burial Expenses Incurred by Primary Beneficiary
The categories for medical, college, burial and funeral expenses now include expenses incurred for a primary beneficiary. A primary beneficiary is someone named as a beneficiary who has an unconditional right at the employee’s death to at least a part of the employee’s account balance.
Comment: This change would open things up for employees who name their domestic partner as a primary beneficiary of their 401(k) or 403(b) plan.
Casualty Loss to Principal Residence Clarified
This safe harbor rule is triggered by uninsured expenses that would qualify for a casualty loss deduction due to damage to the taxpayer’s primary residence.
Historically, it did not matter what caused the damage for purposes of the casualty loss deduction. The important fact was the damage.
Temporary changes made by the Tax Cuts and Jobs Act of 2017 added some confusion, however. Under the change, the casualty loss deduction itself is available only to the extent the loss is caused be a federally declared disaster. This change applies for tax years 2018 through 2025.
The regulations clarify that the IRS is not importing this temporary restriction in the casualty loss deduction into the safe harbor casualty loss category. So damage to the a principal residence caused by normal storm, a mud slide, a fire or whatever can count too.
New Category for Expenses and Losses Due to FEMA Declared Disaster
Historically, safe harbor disaster related damage was limited to damage that would qualify for a casualty loss deduction for damage to the employee’s principal residence. However, the IRS has been making disaster relief in announcements relating to particular declared disaster areas. This relief has been far broader, including expenses and losses caused by the disaster. Loss for this purpose could include lost income. In some instances, disaster distributions would cover expenses and losses incurred by family members. Generally, employers were given extra time to amend their plans.
Employers may now add a new disaster hardship category that includes expenses and losses incurred by the employee by a FEMA declared disaster. To qualify, either the employee’s principal residence or place of employment must be in the disaster area. Employers that choose to include this feature will be able to avoid the delay and confusion of having to wait for specific relief. However, expenses and losses of family members do not count.
New Disaster Safe Harbor Differs from Disaster Relief Announcements
The new disaster safe harbor differs from disaster relief announcements in three ways.
- only expenses and losses of an employee will qualify, not the employee’s relatives and dependents;
- there is no specific deadline by which a request for a disaster-related hardship distribution must be made; and
- there is no extended deadline for plan sponsors to add disaster-related distribution or loan provisions to the plan.
The IRS expects that disaster relief announcements will no longer be needed. However, there might be separate guidance to address delayed amendment deadlines when the new safe harbor expense or loan provisions are added to a plan at a later date in response to a particular disaster.
Dates Changes Apply
The final regulations apply to distributions made on or after January 1, 2020. However, the changes for conditions and safe harbor expenses may be applied to distributions made in plan years beginning after December 31, 2018. The prohibition on suspending an employee’s elective contributions and employee contributions as a condition of obtaining a hardship distribution may be applied as of the first day of the first plan year beginning after December 31, 2018, even if the distribution was made in the prior plan year.
These changes are good news for employers because they can simplify their hardship distribution request procedures. They are good news for employees who will have an easier time accessing hardship distributions. The only downside is that it will be easier for employees to drain their retirement savings before retirement. However, the prohibit on any condition that limits future contributions should mitigate this problem.
By James Solheim, J.D.