The Internal Revenue Service recently published final regulations modifying the rules relating to hardship distributions from Sections 401(k) and 403(b) plans. The final regulations reflect statutory changes affecting Section 401(k) and 403(b) plans, including changes made by the Bipartisan Budget Act of 2018.
The final regulations are substantially similar to the proposed regulations issued in November 2018, and plans that complied with the proposed regulations will satisfy the final regulations.
Key changes to the hardship distribution rules include:
- Modification of the Safe Harbor List of Expenses. The final regulations modify the safe harbor list of expenses for distributions that are deemed to be made on account of an immediate and heavy financial need. The final regulations:
- Added “primary beneficiary under the plan” as an individual for whom qualifying medical, educational and funeral expenses may be incurred. A participant’s “primary beneficiary under the plan” is an individual who is named as a beneficiary under the plan and has an unconditional right to all or a portion of the participant’s account balance under the plan upon the death of the participant.
- Clarified that the Code Section 165 home casualty loss safe harbor covers loss expenses regardless of whether the damage resulted from a federally-declared disaster.
- Expanded the list of safe harbor expenses to include a new “FEMA declared disaster” category. Under this new category, hardship distributions may be made for expenses and losses incurred by an employees because of a federally declared disaster provided that the participant’s principal residence or place of employment at the time of the disaster is in the designated disaster area.
- Unlike previous disaster-relief announcements from the IRS, this new safe harbor category is narrower in three main respects: (1) it only applies to disaster-related expenses and losses incurred by an employee who lived or worked in the disaster area and not expenses and losses of the employee’s relatives and dependents, (2) there is no specific deadline by which a disaster-related hardship distribution must be made, and (3) there is no extended deadline for plan sponsors to add disaster-related distribution provisions to the plan.
- Changes to the Rules for Determining whether a Distribution is Necessary to Satisfy a Financial Need.
- Distribution Deemed Necessary to Satisfy Immediate and Heavy Financial Need. The final regulations, like the proposed regulations, modify the safe harbor necessity standard by eliminating:
- The six-month suspension of employee contributions after a hardship distribution. The final regulations provide that the prohibition on suspension of employee contributions is mandatory and applies to 401(k) plans, 403(b) plans and eligible governmental 457(b) plans. Nonqualified deferred compensation plans subject to Section 409A of the Code may retain such suspension provisions or, to the extent consistent with Section 409A, may be amended to remove them.
- The requirement that the participant take any plan loans prior to obtaining a hardship distribution. This is an optional provision and a plan may continue to require a participant obtain a plan loan before a hardship distribution.
- Creates One General Standard for Determining whether a Distribution is Necessary to Satisfy Need. The final regulations replace the facts and circumstances test for determining if a hardship distribution is necessary to satisfy the financial needs with a general standard that requires:
- The hardship distribution may not exceed the amount of the employee’ need (including any amounts necessary to pay federal, state or local income taxes or penalties);
- The employee must have obtained other available non-hardship distributions under the employer’s plans; and
- The employee must represent that he or she has insufficient cash or other liquid assets “reasonably available” to satisfy the need and the plan administrator has no actual knowledge to the contrary.
- The final regulations state that an employee can make this representation even if the employee did have cash or other liquid assets on hand, provided that those assets were earmarked for payment of an obligation in the near future (for example, rent).
- The employee representation can be made in writing, by electronic medium, or by verbal representation via telephone if the call is recorded.
- The final regulations clarify that plan administrators are not required to inquire into the financial condition of employees who seek hardship distributions.
- Expanding the Contribution Sources. The final regulations, like the proposed regulations, allow hardship distributions to be taken from election contributions, qualified nonelective contributions (QNECs) and qualified matching contributions (QMACs) and earnings on these amounts, regardless of when contributed or earned. The final regulations clarify that safe harbor contributions made to a Section 401(k)(12) safe harbor plan may be distribution on account of hardship.
- Income attributable to elective deferrals in Section 403(b) plans may not be distribution on account of hardship. Further, QNECS and QMACS in Section 403(b) plans that are not in a custodial account may be distribution on account of hardship but such contributions that are in a custodial account are not eligible for distribution on account of hardship.
Effective Dates and Plan Amendments
The changes made by the final regulations are generally effective for distributions on and after January 1, 2020; however, plan sponsors may implement these changes for plan years beginning after December 31, 2018. Note that the elimination of the six-month suspension on employee contributions and the employee representation requirement, both of which are mandatory changes, apply to hardship distributions on or after January 1, 2020.
Plan sponsors will need to amend their plans to comply the final regulations and the deadline for amending individually designed plans is the second calendar year that begins after the issuance of the Required Amendments List, which should December 31, 2021 if the final regulations are included in the 2010 Required Amendments List. The IRS has extended the deadline for adopting an amendment for a pre-approved plan to the 2020 tax filing deadline, plus extensions. For Code Section 403(b) plans, the deadline to adopt amendments for the final regulations is March 31, 2020, but the IRS and Treasury Department are considering providing a later amendment deadline.
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