How hard should a hardship be to justify a hardship withdrawal from a 401(k) plan? Proposed IRS regulations could enable eligible plan participants “to access their money more quickly with a minimum of red tape,” according to the IRS. Below summarizes several key provisions of the proposed regulations.
The status quo
To provide context for the proposed changes, here is where things currently stand. These are, and continue to be under the proposed regulations, the most accommodating rules you can require your participants to follow. However, you also can be more restrictive.
IRS rules require that hardship distributions be made “on account of an immediate and heavy financial need of the employee” and “the amount must be necessary to satisfy the financial need.” Whether a need is immediate and heavy depends on the facts and circumstances. Plan sponsors are required to review “all relevant facts and circumstances” before agreeing to permit a hardship withdrawal.
The rules, however, provide several safe harbors under which plan sponsors do not need to make a judgment call. These involve:
- Medical expenses for the participant or the participant’s family members;
- Costs directly related to the purchase of a principal residence (excluding mortgage payments);
- Tuition, related educational fees, and room and board expenses for the next 12 months of postsecondary education for the participant or the participant’s family members;
- Payments necessary to prevent eviction from the participant’s primary residence;
- Certain expenses to repair damage to the participant’s primary residence; and
- Funeral expenses for the participant or the participant’s family members.
The 2018 Bipartisan Budget Act’s proposed regulations include these same safe harbors and added several new categories, including expenses stemming from a federally declared disaster, such as a major hurricane, and medical, educational and funeral expenses for a beneficiary that is not a dependent.
Three key changes
The proposed regulations make three key changes to hardship withdrawal rules, each of which modifies and relaxes several hardship withdrawal rules:
- Relief from Using Available Plan Loans
Before taking a hardship withdrawal, participants will no longer be required to show they have borrowed all that they can using available plan loans.
- Source of Distributions from Plan Contributions and Earnings
Participants can draw hardship distributions from qualified nonelective contributions, qualified matching contributions, employer safe harbor contributions and earnings on those contributions as well as earnings on elective deferrals.
- No Waiting Period to Resume Contributions
Effective January 1, 2020, plan sponsors will no longer be able to require a participant who has taken a hardship withdrawal to wait six months before resuming plan contributions. Unlike the first two, this change is not optional for plans that allow hardship withdrawals.
Plan sponsors may amend their plans to implement the above changes in 2019. However, plan sponsors should coordinate these changes with their recordkeeper to make sure their design decisions will be implemented properly.
Beginning in 2020, plan sponsors would also be able to take advantage of a liberalized standard for policing participant compliance with eligibility requirements for hardship withdrawals. Specifically, participants will only need to “represent, in writing, by an electronic medium … that he or she has insufficient cash or other liquid assets to satisfy his or her hardship need,” unless the plan sponsor or plan administrator “has actual knowledge to the contrary.”
What is “actual knowledge to the contrary”? For example, suppose a plan sponsor learns something that suggests that a participant is not as financially challenged as he or she has represented, or if the participant recently received a bonus award. Would that represent “knowledge” on the plan sponsor’s part, or only evidence for speculation about the participant’s financial position? It is unclear at this time and a concern for plan sponsors to consider.
The proposed regulations might prompt you to rethink your current policy on hardship withdrawals. Remember, plans are not obligated to allow hardship withdrawals. Look for the final version of the regulations later this year.
Sidebar: How should plan sponsors respond to the changes?
Employers could consider several options with respect to the proposed IRS regulations on hardship withdrawals. Other than dropping the six-month cool off provision, plan sponsors could decide to:
- Not implement some or all of the optional changes made by the proposed regulations;
- Make their plans’ hardship withdrawal requirements more stringent; or
- Stop allowing hardship distributions altogether.
Plan sponsors might eliminate hardship withdrawals when they believe participants who use that option are doing themselves more financial harm than good. Statistics show that leakage from plans is a significant issue as participants deplete their retirement savings. Liberalizing hardship rules may further exacerbate leakage in the future.
Typically, younger participants taking hardship withdrawals tend to wait longer to resume contributing to their accounts. According to the Employee Benefit Research Institute, the lowest income quartile of participants who take a hardship distribution and wait two years before resuming deferrals take a 25% hit on their ultimate retirement savings accumulations when they stop working.
Still, most retirement plans do allow hardship withdrawals. Sponsors who worry about the long-term impact of such distributions can take other steps to minimize leakage, including limiting the size of distributions and allowable reasons. For example, a plan sponsor might decide that the financial burden of a home purchase or college tuition payment does not qualify as a hardship distribution under its plan.
Plan sponsors should consider creating a communication program tailored to participants who take (or are considering taking) hardship withdrawals including encouraging participants to promptly resume their deferrals soon after taking a hardship withdrawal.