Retirement plan administration should be fairly straightforward, based as it is on statutes, regulations written to interpret the statutes, and other levels of official guidance issued by governing federal agencies. But even though plan administration is heavily structured and illuminated by many levels of guidance, there can still be occasional uncertainty—and even controversy.
Hardship distributions are a good example of this. Congress created these distributions so certain eligible individuals could use plan assets for reasons other than retirement. To qualify for a hardship distribution, a participant must have an immediate and heavy financial need, lack other means to satisfy the financial need, and document the reason for and the amount necessary to satisfy the financial need.
The following “safe harbor” reasons are deemed to satisfy the immediate and heavy financial need requirement.
- Medical care for the employee or the employee’s spouse, child, dependent, or primary beneficiary under the plan that is otherwise deductible under Internal Revenue Code Section (IRC Sec.) 213(d).
- Costs directly related to the purchase of a principal residence.
- Payment of post-secondary education expenses (e.g., tuition, related educational fees, room and board expenses) for the employee or the employee’s spouse, child, dependent, or primary beneficiary under the plan. The expenses must be incurred within 12 months of taking the hardship distribution.
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of 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.
- Expenses for the repair of damages to the employee’s principal residence that would qualify for the casualty deduction under IRC Sec. 165.
Treasury regulations and the IRS newsletter
Confirming that a participant qualifies for a hardship distribution is clearly necessary. But what is considered an acceptable procedure for confirmation has varied in the retirement industry. This became apparent in 2015 after the IRS Employee Plans (EP) division published a newsletter describing standards that plan administrators should follow to substantiate hardship distributions.
Treasury regulations allow plan participants to self-certify that a hardship distribution is their only option to satisfy an immediate and heavy financial need; they are not required to provide financial records showing a lack of other options. The regulations, however, are noticeably silent regarding participants self-certifying the reason for the hardship distribution, or the amount necessary to satisfy the need.
The 2015 EP newsletter stated that a qualification failure will occur if employers make hardship distributions without requiring—and maintaining—credible evidence confirming both a valid reason for the hardship distribution requested and a need for the specific amount requested.
The EP newsletter surprised some who believed that self-certification is available for all purposes—including the reason for and the amount of the distribution needed.
IRS internal memorandum sheds new light
In February 2017, the IRS issued an internal memorandum directed to its audit field staff. The memorandum elaborates on 401(k) plan safe harbor hardship approval procedures and accompanying documentation that should be sought from plans under audit. According to this memorandum, documentation must be sufficient to show that the hardship distribution was made because of an immediate and heavy financial need. In March 2017, the IRS issued a follow-up memorandum indicating that the same verification procedures apply to 403(b) plans.
Two verification approaches
According to the IRS, documenting an immediate and heavy financial need for hardship distributions made under the safe harbor rules described earlier can be evidenced by either
- source documents, (e.g., estimates, contracts, bills, statements); or
- a summary of information from source documents.
Whichever approach is taken (source documents or a summary), there must be sufficient detail to support the need for a hardship distribution.
More detail may be requested
If a summary detailing an employee’s financial need is incomplete or inconsistent, IRS examiners are instructed to request source documents. If a summary appears complete, but an employee has received more than two hardship distributions in one plan year, then examiners should obtain either an explanation (e.g., subsequent medical or funeral expenses) or source documents to support the need for multiple hardship distributions.
“Summary” comes with strings
If a summary (rather than source documents) is used to substantiate a hardship distribution, participants must receive a notice explaining that
- hardship distributions are taxable and additional taxes may apply;
- distribution amounts cannot exceed the immediate and heavy financial need;
- hardship distributions cannot be made from earnings on elective contributions or from qualified nonelective contribution (QNEC) or qualified matching contribution (QMAC) accounts, if applicable; and
- distribution recipients must agree to preserve source documents and to make them available at any time, upon request, to the employer or administrator.
In addition to the notice, the summary provided by the participant must contain the information listed below.
I. General Information for All Hardship Requests
- Participant’s name
- Total cost of the event causing hardship (e.g., total cost of medical care, total cost of funeral/burial expenses, payment needed to avoid foreclosure or eviction)
- Distribution amount requested
- Certification by the participant that the information provided is true and accurate
II. Specific Information on Deemed Hardships
A. Medical Care
- Name of the individual who incurred the medical expenses
- Relationship to the participant (self, spouse, dependent, or primary beneficiary under the plan)
- Purpose of the medical care (not the actual condition but the general category of expense, such as diagnosis, treatment, prevention, associated transportation, long-term care)
- Name and address of the service provider (hospital, doctor/dentist/chiropractor/other, pharmacy)
- Amount of medical expenses not covered by insurance
B. Purchase of Principal Residence
- Whether this will be the participant’s principal residence
- Address of the residence
- Purchase price of the principal residence
- Types of costs and expenses covered (e.g., down payment, closing costs, title fees)
- Lender’s name and address
- Date of the purchase/sale agreement
- Expected date of closing
C. Educational Payments
- Name of the individual the educational payments are for
- Relationship to the participant (self, spouse, child, dependent, or primary beneficiary under the plan)
- Name and address of the educational institution
- Categories of educational payments involved (post-high school tuition, related fees, room and board)
- Period covered by the educational payments (beginning/end dates of up to 12 months)
D. Foreclosure/Eviction from Principal Residence
- Whether this is the participant’s principal residence
- Address of the residence
- Type of event (foreclosure or eviction)
- Name and address of the party that issued the foreclosure or eviction notice
- Date of the notice of foreclosure or eviction
- Due date of the payment to avoid foreclosure or eviction
E. Funeral and Burial Expenses
- Name of the deceased
- Relationship to the participant (parent, spouse, child, dependent, or primary beneficiary under the plan)
- Date of death
- Name and address of the service provider (cemetery, funeral home, etc.)
F. Repairs for Damage to Principal Residence
- Whether this is the participant’s principal residence
- Address of the residence that sustained damage
- Brief description of the cause of the casualty loss (e.g., fire, flooding, type of weather-related damage), including the date of the casualty loss
- Brief description of the repairs, including the dates of repair (in process or completed)
Memorandum miscellany, effective date
As stated in the IRS memorandum, if an examiner determines that the requirements have been met, the plan can be treated as having satisfied the hardship distribution substantiation requirement.
If a third-party administrator (TPA) compiles the summary based on source documents, the memorandum states that an examiner should determine whether the TPA has provided the employer with a report or other access to data—at least annually—describing the hardship distributions granted during the plan year.
The guidance in this IRS memorandum is effective for examinations that are in progress or are opened on, or after February 23, 2017.