Proposed Regulations on 401(k) Hardship Withdrawals

Last month, the Treasury Department issued highly anticipated proposed regulations governing hardship withdrawals from 401(k) plans. The proposed regulations address recent statutory changes made to the hardship withdrawal rules under Code Section 401(k), 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 proposed regulations eliminate the requirement under the existing regulatory safe harbor to suspend the participant’s elective deferrals or employee contributions for a period of six months following receipt of a hardship withdrawal. The proposed regulations also update the list of deemed “immediate and heavy 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 proposed regulations 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 participant’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 participant 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 participant must represent that he or she has insufficient cash or other liquid assets to satisfy the financial need. A plan administrator may rely on the participant’s representation unless the plan administrator has actual knowledge to the contrary. Given the timing of the publication of the proposed regulations, the requirement to obtain this representation would apply only for distributions made on or after January 1, 2020.

The proposed regulations provide that a 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. However, the proposed 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. In light of the timing of the publication of the proposed regulations, this prohibition would apply only for hardship withdrawals made on or after January 1, 2020 (but, as explained below, plan sponsors may choose an earlier implementation date).

Effective/Applicability Date

The proposed regulations generally would apply to hardship withdrawals made in plan years beginning after December 31, 2018. In particular, the proposed regulations provide that 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. Accordingly, 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 receives a hardship withdrawal in the second half of 2018 will be suspended from making contributions only until January 1, 2019, or (2) may continue to provide that contributions will be 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.

Plan Amendments and Next Steps

The Treasury Department and IRS expect that plan sponsors will need to amend the hardship withdrawal provisions in their 401(k) plans if the regulations are finalized as they have been proposed. As a rule, individually designed plans would have until the end of the second calendar year that begins after the IRS issues a “Required Amendments List” that includes the change to be amended for such change, and pre-approved plans (e.g., volume submitter and prototype plans) may need to adopt interim amendments in 2019. In the meantime, 401(k) plan sponsors should contact their plan recordkeeper/third-party administrator as soon as possible to confirm (1) the changes the plan sponsor intends to implement with respect to the hardship withdrawal rules, including when they will take effect, and (2) that the recordkeeper’s/third-party administrator’s systems will be timely updated to administer the changes the plan sponsor desires to implement.

Note for 403(b) Plan Sponsors

The proposed new rules relating to hardship withdrawals of elective deferrals from a 401(k) plan generally apply to 403(b) plans. 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.