IRS Publishes Final Regulations on 401(k)/403(b) Hardship Distributions

The IRS has issued final regulations amending the rules governing hardship distributions from 401(k) and tax-sheltered annuity 403(b) plans that reflect statutory changes, including changes made by the Bipartisan Budget Act of 2018. The new rules, published on September 23, add a disaster expense safe harbor, and make it simpler for employers to determine whether an employee qualifies for a distribution. Thus, these changes should enable employers to streamline their hardship distribution request procedures, while making it easier for employees to access hardship distributions.

The final regulations largely reflect the proposed regulations the IRS published in November 2018, and include clarifications on the changes and plan amendment timing. Hardship distributions permit 401(k) or 403(b) plan participants to receive an in-service distribution of elective deferrals and certain other amounts from their accounts, prior to reaching age 59½, if the distribution is necessary to meet "an immediate and heavy financial need." A plan is not required to offer hardship distributions, but it must meet certain requirements if it does offer hardship distributions.

Historically, a plan administrator could determine whether a plan participant satisfies these requirements based on all relevant facts and circumstances, including specified "safe harbor" hardship withdrawals that are deemed to meet an immediate and heavy financial need, such as medical expenses, educational expenses, or payments to avoid eviction or foreclosure. The final regulations, generally following the proposed regulations, make a number of changes to these rules to expand access to retirement funds when a participant is in need.

The final regulations provide two mandatory changes and several optional changes to the hardship distribution requirements. The first mandatory change is the elimination of the six-month suspension rule, which prevents participants who have taken hardship distributions from contributing to the plan for six months following the hardship distribution. This is a required change on or after January 1, 2020, but a plan may elect to remove the six-month suspension requirement as early as January 1, 2019.

The second required change removes the rules under which the determination of whether a distribution is necessary to satisfy a financial need is based on all the relevant facts and circumstances, and provides one general standard for determining whether a distribution is necessary. The conditions for a hardship distribution under the new standard are that the distribution may not exceed the amount of need, including taxes and penalties resulting from the distribution; and that the employee has accessed all other "reasonably available" non-hardship distributions under any of the employer's plans, and has provided written representation that he or she has insufficient cash or other liquid assets to satisfy the immediate and financial need. The plan administrator may rely on the employee's representation, unless the employer has actual knowledge to the contrary, that the need cannot reasonably be relieved from other specified resources. Plans are required to apply this standard starting in 2020.

Among the optional changes is the expansion of available hardship distribution sources to include qualified non-elective contributions (QNECs), qualified matching contributions (QMACs), earnings on these amounts, and earnings on elective deferrals, regardless of when they were contributed or earned. However, for 403(b) plans, the regulations only permit hardship distributions on QNECs and QMACs that are not held in a custodial account, while hardship distributions from earnings on elective contributions continue to be prohibited.

In addition, plan sponsors may remove the requirement that participants take all available non-taxable plan loans, as well as the requirement that the employee first take any insurance or other reimbursement, liquidate assets, and borrow from commercial sources, before taking a hardship distribution. However, participants must still take all other in-service distributions available under the plan.

The regulations also permit plan sponsors to expand the situations deemed to create an immediate and heavy financial need to include expenses and losses incurred by the employee because of a FEMA-declared disaster, if the employee's principal residence or place of employment was in a disaster area at the time of the disaster. According to the IRS, it will no longer need to make special announcements to permit hardship withdrawals for those affected by federally declared disasters. The regulations also clarify that home casualty losses do not have to be tied to a federally declared disaster to be eligible for a hardship distribution, and that the expenses and losses of the employee's relatives and dependents are ineligible.

In addition, under the new regulations, employers have to option to expand the circumstances under which a hardship distribution is permitted for medical, educational, and funeral expenses to include expenses incurred for a primary beneficiary. A primary beneficiary is an individual named as a beneficiary who has an unconditional right at the employee's death to all or a portion of the employee's account balance.