On February 23, 2017, the IRS issued a memo on substantiation guidelines for safe-harbor hardship distributions from 401(k) plans.  This memorandum was sent to all employee plans (EP) examination employees.  The memo covers whether or not a 401(k) plan hardship distribution is “deemed to be on account of an immediate and heavy financial need” under safe harbor standards set out in the Income Tax Regulations.  It was noted that these guidelines do not address non-safe-harbor distributions.

Background

Under the Income Tax Regulations the following items are deemed to be for an immediate and heavy financial need:

  1. Expenses for medical care deductible under section 213(d) for the employee or the employee’s spouse, children or dependents or primary beneficiary under the plan.
  2. Costs directly related to the purchase of a principal residence.
  3. Payments of tuition, related fees, room and board expenses for up to the next 12 months of post-secondary education for the employee or the employee’s spouse, children or dependents or primary beneficiary under the plan.
  4. Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence.
  5. Payments for burial or funeral expenses for the employee’s deceased parents, spouse, children or dependents or primary beneficiary under the plan.
  6. Expenses for the repair of damages to the employee’s principal residence that would qualify for the casualty deduction under section 165.

Examination Guidelines

Substantiation that a distribution is for one of the items above is required and the memo lays out the following steps to determine such:

Step 1

  • Determine whether the employer or third-party administrator (TPA) obtains source documents or a summary of the information contained in the source documents.
  • If a summary is used, determine whether the employer or TPA provides the employee notifications required below prior to making a hardship distribution
    • Notifications that the Employer/Administrator Must Provide to the Employee
      • The hardship distribution is taxable and additional taxes could apply.
      • The amount of the distribution cannot exceed the immediate and heavy financial need.
      • Hardship distributions cannot be made from earnings on elective contributions or from QNEC or QMAC accounts, if applicable.
      • The recipient agrees to preserve source documents and to make them available at any time, upon request, to the employer or administrator.

Step 2

  • If the employer or TPA obtains source documents under Step 1(a) above, review the documents to determine if they substantiate the hardship distribution
  • If the employer or TPA obtains a summary of information under Step 1(b), review the summary to determine whether it contains the items listed in the IRS memorandum.
  • If the notification provided to employees or the information reviewed is incomplete or inconsistent on its face, the examination employee may ask for source documents from the employer or TPA.
  • If the summary of information reviewed is complete and consistent but employees have received more than 2 hardship distributions in a plan year, then in the absence of an adequate explanation, the examination employee may ask for source documents from the employer or TPA.
  • If a TPA obtains a summary of information contained in source documents, determine whether the TPA provides a report or other access to the employer at least annually describing the hardship distributions.

 

Conclusion

The steps above will be applied to examinations upon the date of issuance of the memo which is listed above.  Employers should review their policies and procedures around substantiation of the hardship distribution and whether or not the distributions were on account of an immediate and heavy financial need. If you have any questions, please contact a Barnes Dennig representative here.