On November 9, 2018 the IRS issued proposed regulations that clarify changes made by the Bipartisan Budget Act of 2018, which generally expanded the ability of participants in 401(k) and 403(b) plans to obtain a hardship distribution. The proposed regulations generally:
  • Clarify and expand the situations deemed to constitute an “immediate and heavy financial need” under the regulatory safe harbor guidelines;
  • Repeal the six-month suspension of deferrals after taking a distribution, which is mandatory starting in 2020, and modify other actions required of plan participants to demonstrate that a hardship distribution amount is necessary to satisfy the financial need; and
  • Expand the types of plan contributions that can be used to fund a hardship distribution, with some of the expansions not applying to 403(b) plans.
  • Apply effective January 1, 2020, with some provisions able to be relied on in 2019.

I. Situations Deemed to Constitute an Immediate Heavy Financial Need

Existing 401(k) regulations designate six scenarios that are deemed to constitute an “immediate and heavy financial need,” and therefore justify a hardship distribution. Referred to as hardship distribution “safe harbors,” these situations include the following situations:

  • uninsured medical expenses for the plan participant or a family member;
  • payment of tuition or related post-secondary educational expenses for the next 12 months for the participant or a family member;
  • payments for burial or funeral expenses of a participant or family member;
  • payments to prevent eviction of the participant;
  • costs related to the participant’s purchase of a principal residence; and
  • expenses related to the repair of damages to a participant’s principal residence, if the expense would qualify for a casualty deduction under Section 165 of the Internal Revenue Code (the “Code”), regardless of whether the loss exceeds 10 percent of adjusted gross income.

The proposed regulations clarify changes made under prior legislation, which enabled distributions on account of the first three safe-harbor situations listed above (i.e., uninsured medical expenses, tuition/educational expenses and burial/funeral costs) to cover a participant’s designated beneficiary under the plan, as well as the participant and family members. (Many plans have already made those changes.) The proposed regulations also clarify that the last listed safe-harbor situation (home repair expenses) will apply without regard to additional restrictions placed on Code Section 165 damage claims. (In short, for purposes of determining whether a participant’s situation meets the safe harbor standard for a hardship distribution, their home will not have to be in a federally declared disaster area.)

Finally, the proposed regulations designate a new seventh safe harbor situation. The new safe harbor standard includes expenses and losses (including loss of income) incurred by a participant on account of a disaster declared by the Federal Emergency Management Agency (FEMA), provided the participant’s principal place of residence or principal place of employment at the time of the disaster was located in an area designated by FEMA for individual assistance with respect to the disaster.

II. Distributions Deemed Necessary to Satisfy Financial Need

Under current IRS regulations, to satisfy a safe harbor hardship scenario the participant must suspend employee contributions to the plan for six months following the hardship distribution. The Bipartisan Budget Act directed the IRS to remove that requirement within one year, but it was unclear if the change would be mandatory or the plan sponsor’s choice. The proposed regulations clarify that removal of the suspension is mandatory for distributions made on or after January 1, 2020. In other words, a plan may not require that a suspension of employee contributions is a condition for obtaining a hardship distribution. However, with respect to hardship distributions in 2019, and even some distributions that occurred in 2018, a plan can choose whether to impose a six-month suspension condition. For example, assume a participant obtained a hardship distribution October 1, 2018. The normal six-month suspension rule would preclude that employee from making employee contributions to the plan until April 1, 2019. The proposed regulations clarify that the six-month prohibition may continue to apply for the full six months, or may be terminated effective January 1, 2019, so that the participant could again begin making employee contributions.

Existing 401(k) regulations also require that before obtaining a hardship distribution, a participant must first seek all currently available distributions from other retirement plans of the employer, as well as any available loans. The proposed regulations eliminate the plan loan requirement for hardship distributions made on or after January 1, 2020. Unlike the six-month exclusion from employee contributions, a plan may continue to require a participant to obtain a plan loan before being deemed eligible to receive a hardship distribution. This is a discretionary design choice of the plan sponsor.

Finally, for hardship distributions made on or after January 1, 2020, a plan participant must represent in writing, by an electronic medium, or [not “on”] such other form as may be dictated by the IRS, that he or she has insufficient cash or other liquid assets to satisfy the immediate and heavy financial need. A plan administrator may rely on the employee’s representations, unless the plan administrator has actual knowledge to the contrary. This will facilitate automated approval and recordkeeping for hardship distributions.

III. Types of Plan Contributions That May Fund a Hardship Distribution

Historically, hardship distributions were limited to an employee’s contributions (both pre-tax and after-tax), exclusive of investment earnings on employee pre-tax contributions. Similarly, a hardship distribution could not be drawn from any qualified nonelective contributions (“QNECs”) or qualified matching contributions (“QMACs”), which are employer contributions used to satisfy nondiscriminatory testing concerns, and are subject to the same distribution restrictions applicable to pre-tax salary deferral contributions. Under the proposed regulations, investment earnings, QNECs and QMACs may be used to satisfy a hardship distribution on or after January 1, 2019, regardless of when the earnings accrued or the QNECs or QMACs were contributed. In the same fashion, 401(k) safe harbor contributions (both nonelective and matching) are also available for hardship distributions. Note that plan sponsors may design their plans to limit access to certain types of contributions. For example, just because earnings are allowed by law to be distributed as part of a hardship distribution, a plan may still be designed to limit hardship distributions to deferrals only.

IV. Parallel Changes for 403(b) Plans, With Some Exceptions

The rules described above generally apply to hardship distributions under both 401(k) and 403(b) plans as well. However, when the Bipartisan Budget Act of 2018 revised the rule applicable to 401(k) plans regarding investment earnings, QNECs and QMACs, it did not make a comparable change to Code Section 403(b)(11), governing 403(b) plans that utilize custodial accounts. Therefore, a hardship distribution from 403(b) plan that operates through a custodial account may not use money stemming from investment earnings on elective deferrals, QNECs or QMACs as part of a hardship distribution. 

V. Plan Amendments and Timing

Under the proposed regulations, the deadline for amending a plan with respect to the hardship distribution changes will be the end of the second calendar year that begins after the corresponding issuance of the Required Amendments List. This is a lengthy period, and many plan sponsors will likely amend prior to the deadline. Also, as noted above, a plan may not impose a six-month employee contribution suspension requirement as a condition for receiving a hardship distribution on or after January 1, 2020.

VI. Recommended Next Steps

Sponsors of 401(k) and 403(b) plans that offer hardship distributions should take the following actions:

  • If the plan permits hardship distributions, determine whether the plan relies on the safe harbor hardship distribution provisions, and if so, whether there is a desire to expand a hardship distribution opportunity, as afforded by the proposed regulations. 
  • With respect to the six-month suspension rule, determine whether the requirement should be removed effective on  January 1, 2020, or earlier, and if earlier, how should the prohibition apply for hardship distributions made in the second half of 2018—i.e., continue for the full six months, or end on January 1, 2019?
  • After reaching the decisions discussed above, coordinate with legal counsel or the plan advisor to amend the plan accordingly.