Under the terms of the Internal Revenue Code (Code), participants in 401(k) plans are restricted from withdrawing their salary deferral contributions from the plan while they are still employed.
There are some limited exceptions which permit withdrawals. One of the exceptions is the ability to withdraw salary deferral contributions on account of “an immediate and heavy financial need.” The Internal Revenue Service (IRS) has identified a safe harbor list of financial events that potentially will give rise to a need for a distribution. These events include distributions to satisfy:
- Expenses for medical care deductible under the Code for the participant or the participant’s spouse, children or dependents;
- Costs directly related to the purchase of a principal residence;
- Payment of tuition, related educational fees, room and board expenses for up to the next 12 months of post-secondary education for the participant or the participant’s spouse, children or dependents;
- Payments necessary to prevent the eviction of the participant from the participant’s principal residence or foreclosure of the mortgage on that residence;
- Payments for burial or funeral expenses for the participant’s deceased parents, spouse, children or dependents; and
- Expenses for the repair of damages to the participant’s principal residence that would qualify for the casualty deduction under the Code.
If a participant has incurred such an event and wishes to take a distribution, the participant must be able to substantiate the financial reason for the distribution and the amounts necessary to satisfy the need.
As more and more plans move away from paper forms and direct employer involvement by replacing them with electronic sites run by outside third-party administrators, the risk has been that the substantiation requirement may get overlooked to the detriment of the qualified status of the plan and the participant. The troubling question lingering in the background is what information should the plan be requiring the participant provide to document the existence of the hardship and to verify the amount needed to satisfy it. Many plans and many outside third-party administrators relied solely on a participant’s attestation regarding the existence of a hardship and the amount needed to satisfy it. The IRS had said for many years that was not sufficient. But until the plan was audited, nobody much worried about it.
In a recent memorandum issued by the IRS for its 401(k) audit examiners, the IRS has indicated that the auditors who are reviewing hardship distributions for their compliance with the requirements of the Code may either look at actual documents such as estimates, contracts, bills, and statements from third parties verifying the hardship or alternatively they may look at summaries of the information contained in such documents. Such summaries can be on paper, in electronic format or in telephone records. The memorandum addressed 401(k) audits, but the IRS in a separate memorandum directed its 403(b) auditors to follow the same protocol when looking at hardship distributions from 403(b) plans.
The alternative of reviewing a summary to verify hardship distributions is welcome news. Many plans, as described above, have relied on a simple check-the-box on a website or a telephone call to an outside third-party administrator from the participant about the existence of a hardship.
While following the steps in the memorandum is a bit more work than many plans or outside third-party administrators are used to doing, it provides a framework for plan sponsors and outside third-party administrators to use to have some reliance that the plan complies with the Code requirements.
For a plan to be able to rely on this type of summary as suggested in the memorandum, the IRS is effectively requiring the following:
- The employer or its third-party administrator should provide a notice to the participant that:
- the hardship distribution is taxable
- the distribution may not exceed the financial need
- distributions cannot be made on earnings on 401(k)/403(b) contributions
- the participant must preserve the actual materials documenting the hardship and provide them on request to the employer or third-party administrator
- The summary information must include:
- participant name
- total cost of the event causing the hardship
- the distribution amount requested
- certification that information is true and accurate
- The summary must also include information specific to the request. For example, if it is for medical expenses it should include:
- who incurred the expense
- relationship to participant
- purpose of medical care
- name and address of provider
- amount not covered by insurance
- If an outside third-party administrator is handling the hardship distribution, it should provide a report to the employer at least annually describing all the hardship distributions done in the year.
The issuance of the memorandum provides plan sponsors with a degree of comfort that they may use alternative methods of verifying and certifying hardship distributions. The memorandum also provides guidance that the electronic and telephonic administration of hardship distributions is acceptable provided the notice is given and summary information is collected.
Plan sponsors and third-party administrators are best advised to review their current practices and where necessary implement practices that would satisfy the requirements of the IRS memorandum.