401(k) Hardship Distributions: IRS Eases Substantiation Requirements

WHAT ARE “HARDSHIP DISTRIBUTIONS”?

General Requirement. To qualify as a “hardship distribution,” the distribution must be: (1) “made on account of an immediate and heavy financial need” and (2) “necessary to satisfy the financial need.”  With regard to the second prong of the test, the applicable regulations expressly permit the plan sponsor to rely on the participant’s representation that the need cannot be reasonably relieved: (1) through reimbursement or compensation by insurance or otherwise; (2) by liquidation of the participant’s assets; (3) by cessation of elective deferrals or other participant contributions under the plan; (4) by other currently available distributions and nontaxable loans under plans maintained by the employer or any other employer; or (5) by borrowing from commercial sources on reasonable commercial terms in an amount sufficient to satisfy the need.

Safe Harbor. The 401(k) regulations establish a “safe harbor” pursuant to which a distribution will be deemed to be “on account of an immediate and heavy financial need.”  Specifically, the distribution will meet this safe harbor if it is made on account of one of six enumerated circumstances:

Distributions may be permitted on account of other circumstances, but they do not fall within the safe harbor and, if not considered a financial hardship by the IRS, can subject the plan to disqualification.  Accordingly, most 401(k) plans are drafted to limit hardship distributions to the safe harbor reasons.

WHAT ARE THE SUBSTANTIATION REQUIREMENTS?

Pre-IRS Audit Guidance.  While the 401(k) regulations allow plan sponsors to rely on a participant’s representation that the distribution was “necessary to satisfy the financial need,” before recent guidance, they could not rely on such representations to satisfy the first prong of the hardship distribution test – i.e., that the distribution was being made on account of an “immediate and heavy financial need.”   Rather, the plan sponsor had to obtain documentary evidence of the expenses that were incurred.  For example, before making a hardship distribution, the plan needed to obtain financial information and documentation, such as loan documents, medical bills, tuition statements, etc., that supported the reason for the distribution. These substantiation guidelines were extremely onerous, and conflicted with the desire of plan sponsors and third-party administrators to move to an administrative process that was largely handled electronically.

Post-IRS Audit Guidance.  Perhaps in recognition of this issue, the IRS recently released a memorandum to its plan examination agents setting forth less burdensome substantiation requirements that could be accepted in an audit of a 401(k) plan that uses the safe harbor standards (the old rules continue to apply to non-safe harbor distributions).  Under the new guidelines, a plan administrator could either obtain “source documents,” such as the type of information required under prior substantiation standards, or a summary of the information contained in source documents.  There are two components of the new substantiation guidelines for plan administrators that accept summary information to support a hardship distribution: (1) participant notification and (2) content of summary information collected.

Participant Notification.  For an employer who is going to accept summary information in substantiation of a hardship distribution request, the participant must be provided with notification that informs him or her of the following facts:

WHAT IS THE POTENTIAL IMPACT? The recently issued IRS memorandum, while not something that plan sponsors are allowed to rely on, indicates that the IRS will be more flexible on audit in finding that plan administrators have properly determined whether hardship distributions are permitted in any given instance.  This change, in turn, should give plan sponsors and administrators greater flexibility in administering their plans’ hardship distribution features and perhaps facilitate the use of an electronic hardship application process, since employers need only obtain summaries of the expenses, and not the actual documentation relating to the expenses, before making a hardship distribution.  Plan sponsors and administrators should keep in mind, though, that for these new guidelines to be used, employees must agree to retain the source documents that support their hardship requests and to produce them in connection with a plan audit upon request.

TAKE AWAYS

Employers should determine whether they wish to take advantage of the greater flexibility afforded in the recently-released IRS audit guidance.  If so, they should prepare documents that (1) set forth the required participant notification and (2) solicit the necessary summary information to support a hardship distribution request.

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