Final Regulations on 401(k) Hardship Withdrawals
In September, the Treasury Department issued final regulations governing hardship withdrawals from 401(k) plans. The final regulations update the existing 2004 regulations to reflect recent statutory changes made to the hardship withdrawal rules under Section 401(k) of the Internal Revenue Code (“Code”), including:
- permitting the withdrawal of earnings on elective deferrals in the event of a hardship;
- permitting the withdrawal of QNECs, QMACs, and earnings on such contributions in the event of a hardship; and
- providing that a distribution will not be treated as failing to be made upon a participant’s hardship solely because the participant does not take any available loan under the plan.
In addition, the final regulations eliminate the requirement under the existing regulatory safe harbor to suspend a participant from making elective deferrals or employee contributions for a period of six months following receipt of a hardship withdrawal. The final regulations also update the list of deemed “immediate and heaving financial needs” by: (1) adding a participant’s “primary beneficiary” as an individual for whom qualifying medical, educational and funeral expenses may be incurred, (2) removing an unintended restriction on qualifying expenses for the repair of damage to a participant’s principal residence, and (3) adding a new expense to the list – expenses and losses (including loss of income) incurred by a participant as a result of a federally-declared disaster, provided the participant’s principal residence or principal place of employment was located in an area designated by FEMA for individual assistance with respect to the disaster.
The final regulations are substantially similar to the proposed regulations issued last year (see our December 11, 2018 blog post here), and 401(k) plans that complied with the proposed regulations will satisfy the final regulations; however, plan sponsors who made changes in response to the proposed regulations should review any prior plan amendments and administrative procedures to ensure that the plan complies, in form (i.e., plan document) and in operation, with the final regulations. For example, plan sponsors who amended their plans for the proposed regulations may wish to further amend their plans for the less strict standard in the final regulations regarding the employee representation requirement described in the following paragraph.
The final regulations also modify the rules for determining whether a distribution is necessary to satisfy an immediate and heavy financial need by eliminating the existing regulatory safe harbor and providing one general standard for determining whether the distribution is necessary. The new general standard has three components. First, a hardship withdrawal may not exceed the amount of the employee’s need (including any amounts necessary to pay any federal, state or local income taxes or penalties reasonably anticipated to result from the distribution). Second, the employee must have obtained all other currently available distributions (including distributions of ESOP dividends) under the plan and all other plans of deferred compensation, whether qualified or nonqualified, maintained by the employer. Third, the employee must represent, in writing (including by using an electronic medium), that he or she has insufficient cash or other liquid assets reasonably available to satisfy the financial need. Importantly, in response to a comment the Treasury Department received on the proposed regulations, the words “reasonably available” were added to the employee representation requirement in the final regulations. By adding these two words, the Department explained that an employee could make the representation that he or she meets this requirement even if the employee has cash or other liquid assets on hand, provided that cash or other assets is earmarked for payment of another obligation in the near future (for example, rent). The employee representation requirement applies only for distributions made on or after January 1, 2020, and a plan administrator may rely on the participant’s representation unless the plan administrator has actual knowledge to the contrary.
The final regulations provide that a 401(k) plan generally may provide for additional conditions to demonstrate that a withdrawal is necessary to satisfy an immediate and heavy financial need. For example, a plan may require a participant to first obtain all nontaxable loans available under the plan before a hardship withdrawal may be made or impose a nondiscriminatory minimum dollar withdrawal amount. However, the final regulations no longer permit a plan to provide for a suspension of elective deferrals or employee contributions as a condition of obtaining a hardship withdrawal. This prohibition applies only for hardship withdrawals made on or after January 1, 2020, but, as explained below, plan sponsors may choose an earlier implementation date.
The final regulations apply to hardship withdrawals made on or after January 1, 2020. However, plan sponsors have the option to apply them sooner -- they may be applied to hardship withdrawals made in plan years beginning after December 31, 2018, and the prohibition on suspending elective deferrals and employee contributions may be applied as early as the first day of the first plan year beginning after December 31, 2018, even if the distribution was made in the prior plan year. This means a calendar year plan providing for hardship withdrawals under the pre-2019 safe harbor standards either (1) may be amended to provide that a participant who received a hardship withdrawal in the second half of 2018 is suspended from making contributions only until January 1, 2019, or (2) may continue to provide that contributions are suspended for the originally scheduled six months. In addition, the revision to qualifying expenses for the repair of damage to a participant’s principal residence may be applied to withdrawals made on or after a date that is as early as January 1, 2018.
If a plan sponsor chooses early application of the final regulations, the new rules requiring an employee representation and prohibiting suspension of elective deferrals and employee contributions may be disregarded with respect to hardship withdrawals made before January 1, 2020.
The Treasury Department and IRS expect that plan sponsors will need to amend the hardship withdrawal provisions in their 401(k) plans to reflect the final regulations. As a rule, individually designed plans have until the end of the second calendar year that begins after the IRS issues a Required Amendments List (“RAL”) that includes the change to be amended for such change. For example, if the final regulations are included in the 2019 RAL, the plan amendment deadline will be December 31, 2021. Pre-approved 401(k) plans (e.g., volume submitter and prototype plans), as well as individually designed and pre-approved 403(b) plans, may have an earlier amendment deadline.
Note for 403(b) Plan Sponsors
The final regulations generally apply to 403(b) plans too. However, earnings attributable to Section 403(b) elective deferrals remain ineligible for distribution on account of hardship, and QNECs and QMACs in a Section 403(b) plan that are in a custodial account continue to be ineligible for hardship withdrawals. QNECs and QMACs in a Section 403(b) plan that are not in a custodial account may be withdrawn in the event of hardship.