IRS Issues Substantiation Guidelines for Safe-Harbor Hardship Withdrawals

Earlier this year, the IRS issued a memorandum setting forth substantiation guidelines for IRS auditors examining whether a 401(k) plan hardship distribution is “deemed to be on account of an immediate and heavy financial need” under certain safe-harbor standards provided in the Treasury regulations.  Last week, the IRS followed-up with another memorandum clarifying that this guidance also applies to 403(b) plans. The guidance highlights how IRS auditors of 401(k) and 403(b) plans will focus their review, and emphasizes the need for proper documentation and internal controls for such distributions. 

A copy of the 401(k) memorandum can be obtained here. A copy of the 403(b) memorandum can be obtained here.

Background

Generally, 401(k) plans may permit distributions of elective deferrals on account of certain financial hardships if two requirements are satisfied: (1) the distribution is made on account of an “immediate and heavy financial need” (Financial Need) and (2) the distribution is necessary to satisfy that Financial Need.   Hardship distributions offered under a 401(k) or 403(b) plan can satisfy these requirements by meeting either a safe-harbor or non-safe-harbor standard set forth in the Treasury regulations. 

• Non-Safe-Harbor Hardship Distributions

Under the non-safe-harbor standard, whether a distribution is made on account of a Financial Need is determined under a facts-and-circumstances analysis.  For example, the need to pay funeral expenses would qualify as a Financial Need, whereas purchasing a boat generally would not.  Under this standard, plan administrators are generally permitted to allow a participant to self-certify that the distribution is necessary to satisfy the Financial Need.

• Safe-Harbor Hardship Distributions

Under the safe-harbor standard, a distribution will be deemed to be on account of a Financial Need if it is for one or more of the following:

• expenses for a medical care deductible under Code Sec. 213(d) for the plan participant or the participant’s spouse, children or dependents or primary beneficiary under the plan;
• costs directly related to the purchase of a primary residence;
• payment of tuition, related educational fees, room and board expenses for up to the next 12 months of post-secondary education for the plan participant or his or her spouse, children or dependents or primary beneficiary under the plan;
• payments necessary to prevent the eviction of the plan participant from his or her primary residence or foreclosure of the mortgage on that residence;
• payments for burial or funeral expenses for the plan participant’s deceased parents, spouse, children or dependents or primary beneficiary under the plan; or
• expenses for the repair of damages to the plan participant’s principal residence that would qualify for the casualty deduction under Code Sec. 165.

A distribution will be deemed as necessary to satisfy the Financial Need if (1) the participant has obtained all other currently available distributions, including distributions of employee stock ownership plan dividends -- but not hardship distributions-- and nontaxable (at the time of the loan) loans, under the plan and all other plans maintained by the employer; and (2) the participant is prohibited, under the terms of the plan or an otherwise enforceable agreement, from making elective deferrals and other employee contributions to the plan and all other plans maintained by the employer for at least six months after receipt of the distribution.

• 403(b) Plans

The Treasury regulations provide that hardship distributions for 403(b) plans have the same meaning and are subject to the same rules and restrictions as are applicable to 401(k) plans. Thus, the safe-harbor and non-safe-harbor hardship distribution standards described above apply to 403(b) plans as well as 401(k) plans.

Regardless of whether a plan uses the safe-harbor or non-safe-harbor standard for hardship distributions, it is critically important that employers properly document and substantiate all hardship distributions made from a plan.   

Substantiation Guidelines

Where a 401(k) or 403(b) plan uses the safe-harbor hardship distribution standard, a distribution will be deemed to have been made on account of a Financial Need if it is made for one or more of the six items specified above.  The recent IRS guidance indicates that if such a plan is being audited, an auditor should substantiate the distribution by taking a two-step approach.

Step One: What Documentation Was Received Before the Distribution? 

The auditor should first determine whether, prior to the distribution, the plan administrator (for example, the employer or a third-party administrator (TPA)) obtained (i) so-called source documents (e.g., estimates, contracts, bills and statements from third parties); or (ii) summaries of the information in a source document (e.g., via paper, electronic or telephonic records) from the participant requesting the distribution. 

If only summaries were provided by the participant, the auditor should determine whether the plan administrator provided the participant the notifications required on “Attachment 1” of each memorandum prior to making the hardship distribution. 

Attachment 1 of each memorandum provides a list of hardship substantiation information and notifications for summary of source documents. Specifically, Attachment 1 provides a list of (i) notifications that the plan administrator must provide to a participant requesting a hardship distribution; (ii) general information that should be obtained for all hardship requests; and (iii) specific information that should be obtained depending on the hardship event (e.g., medical care, purchase of principal residence, educational payments, etc.).

• Required notifications: The plan administrators must provide the following notifications to a participant requesting a hardship distribution:
  • The hardship distribution is taxable and additional taxes could apply;
  • The amount of the distribution cannot exceed the amount of the Financial Need;  
  • Hardship distributions cannot be made from earnings on elective contributions for from qualified nonelective contribution (QNEC) or qualified matching contribution (QMAC) accounts, if applicable.
  • The recipient agrees to preserve source documents and to make them available at any time, upon request, to the employer or plan administrator.
• General information for all hardship requests. The following general information should be obtained for each hardship request:
  • the participant’s name;
  • the total cost of the event causing hardship (e.g., total cost of medical care, funeral/burial expenses or payments needed to avoid foreclosure or eviction);
  • the amount of the distribution requested; and
  • certification by the participant that the information provided is true and accurate.
• Specific information on deemed hardships. Attachment 1 provides a list of specific information that should be obtained depending on the hardship event. For example, the following should be provided for hardship distributions on account of funeral and burial expenses:
  • the name of the deceased;
  • the relationship to the participant (e.g., parent, spouse, child dependent or primary beneficiary under the plan);
  • date of death; and
  • the name and address of the service provider (e.g., cemetery, funeral home, etc.).

Step Two: What Happens Next?

The guidance indicates that the next step in an IRS auditor’s review is determined based on the results from Step One:

• Source documents obtained before the distribution. If the plan administrator obtained source documents from the participant before the distribution, the auditor should review the documents to determine if they substantiate the hardship distribution.
• Only summaries were obtained before the distribution. If the plan administrator obtained only source document summaries from the participant, the auditor should review the summary to determine whether it contains the relevant items listed on Attachment 1.
• Incomplete or inconsistent information. If the notification provided to the participant as to hardship distributions or any source document summary is incomplete or inconsistent on its face, the auditor may ask for source documents from the plan administrator to substantiate the distribution.
• Multiple hardship distributions. If an auditor finds that a participant received more than two hardship distributions in a plan year, then, in the absence of an adequate explanation for the multiple distributions (e.g., follow-up medical or funeral expenses, or tuition on a quarterly school calendar), the auditor may ask for source documents from the plan administrator to substantiate the distributions.
• TPA reports to employers. If a TPA obtained source document summaries, the auditor should determine whether the TPA provided a report or access to the data to the employer plan sponsor, at least annually, describing the hardship distributions made during the plan year.

If the auditor determines that all applicable requirements in Step One and Step Two are satisfied, the plan should be treated as satisfying the substantiation requirement for making hardship distributions deemed to be on account of a Financial Need.

Lessons for Employers

Employers sponsoring 401(k) or 403(b) plans that offer hardship distributions should review their plan documents to determine whether their plans use the safe-harbor or non-safe-harbor standard for such distributions. Although the guidance does not have binding legal or regulatory effect, it nonetheless highlights what auditors of plans offering safe-harbor hardship distributions will be looking for (e.g., the information specified in Attachment 1) and reinforces that plan administrators should be regularly reviewing their record retention practices. It also emphasizes the need for proper documentation and internal controls for such distributions, including, to the extent applicable, understanding between TPAs and employer plan sponsors regarding their respective roles in the review and documentation process, as well as the importance of substantiation before distributions are made.   

Effective Date

The guidance is effective upon the date of each memorandum’s issuance — Feb. 23, 2017, for 401(k) plans and March 7, 2017, for 403(b) plans — and is intended to be applied to examinations open as of each memorandum’s effective date.