The IRS recently published final regulations relating to hardship distributions under 401(k) and 403(b) plans. The final regulations reflect the changes made in the Bipartisan Budget Act of 2018. The final regulations are substantially similar to the proposed regulations issued in 2018, and plans that complied with the proposed regulations will satisfy the final regulations. The final regulations make the following changes and clarifications.
Whether the Distribution Is Necessary to Satisfy a Financial Need
The final regulations modify the rules for determining whether a hardship distribution is necessary to satisfy an immediate and heavy financial need.
First, the regulations eliminate the requirement that an employee be prohibited from making elective contributions and employee contributions for six months after receiving a hardship distribution. This change is required with respect to distributions made on or after January 1, 2020. A plan sponsor can choose to eliminate the six-month suspension period as of the first day of the first plan year beginning on or after January 1, 2019, even if the distribution was made in the prior plan year. The regulations clarify that the prohibition of a suspension period applies to the employer’s qualified, 403(b), and governmental 457(b) plans. Nonqualified deferred compensation plans subject to Code Section 409A retain the ability to include a suspension period (and may also be amended to remove a suspension period, if done in compliance with Code Section 409A).
The final regulations also eliminate the requirement that a participant take available plan loans before receiving a hardship distribution. This change is optional.
In addition to removing the requirements above, the final regulations replaced the old alternative standards for showing that a distribution is necessary to satisfy a financial need (i.e., the facts and circumstances test and the safe harbor) with a single new standard. Under the new standard, a hardship distribution may not exceed the amount of an employee’s need (including any amounts necessary to pay taxes or penalties), the employee must have obtained other available, nonhardship distributions under the employer’s plans, and the employee must have provided a written or electronic representation that he or she has insufficient cash or other liquid assets reasonably available to satisfy the financial need. The plan administrator may not make the hardship distribution if it has actual knowledge contrary to the participant’s representation. This representation is required with respect to distributions made on or after January 1, 2020.
Types of Contributions Available for a Hardship Distribution
Under the old rules, hardship distributions could not be made from earnings attributable to elective contributions. In addition, QNECs, QMACs, safe harbor contributions, and associated earnings were not permitted to be included in a hardship distribution. Under the final regulations, these types of contributions and earnings may be included in a hardship distribution, regardless of when they were contributed or earned. This change is optional, and the plan still retains the right to decide what types of contributions and earnings are available for hardship distributions.
The rules are slightly different with respect to a 403(b) plan. Earnings attributable to 403(b) elective contributions remain ineligible for hardship distributions. Additionally, whether a QNEC, QMAC, or safe harbor contribution in a 403(b) plan is eligible for a hardship distribution depends on whether such amounts are held in a custodial account. Employer contributions that are held in a custodial account remain ineligible for hardship distributions, whereas employer contributions not held in a custodial account are permitted to be included in hardship distributions.
Deemed Immediate and Heavy Financial Need
The final regulations modify the safe harbor list of expenses for which distributions are deemed to be made on account of an immediate and heavy financial need. First, the regulations modify the category of expenses relating to damage to a principal residence that would qualify as a casualty deduction by disregarding new rules that would have required that the losses be the result of a federally declared disaster.
The final regulations have also added a seventh safe harbor category for expenses resulting from a federally declared disaster. Because of the new safe harbor expense, the IRS expects that it will not have further need to issue disaster-relief announcements. The new safe harbor expense differs from prior IRS disaster-relief announcements in three ways:
- Only disaster-related expenses and losses of an employee who lived or worked in the disaster area will qualify for the new safe harbor expense. Under the IRS disaster‑relief announcements, expenses and losses of an employee’s relatives and dependents were also covered.
- Unlike under the disaster-relief announcements, there is no specific deadline by which the request for a disaster-related hardship distribution must be made.
- There is no extended deadline for plan sponsors to add disaster-related distribution provisions to the plan. A plan sponsor who decides not to add this seventh safe harbor category as part of the amendment incorporating the final regulations, but rather waits until a disaster occurs to add such provisions, must adopt a plan amendment by the end of the plan year in which the amendment is first effective.
These two changes to the list of safe harbor expenses are optional and may be used as early as January 1, 2018.
Plan sponsors will need to amend their plans to reflect the final regulations. The deadline to amend an individually designed, nongovernmental, qualified plan is the end of the second calendar year that begins after the final regulations are included in the Required Amendments List. Plan sponsors with preapproved qualified plans have until the deadline for their interim amendments required by the final regulations to adopt interim amendments integrally related to the final regulations. An individually designed or preapproved 403(b) plan must be amended for the final regulations by the end of the remedial amendment period.
The final regulations generally apply to distributions made on or after January 1, 2020, although the regulations may be used with respect to distributions made in plan years beginning on or after January 1, 2019.
Please contact a member of the Employee Benefits team if you have any questions about the final regulations.