401(k) advisers, take heed of guidance on hardship withdrawals for clients

In recent months, the Internal Revenue Service has provided guidance with respect to hardship withdrawals from tax-qualified retirement plans.

Forewarned is forearmed, and in light of this recent series of guidance on possible errors in administering withdrawals, financial advisers should inform their 401(k) plan sponsor clients to determine if operational changes may be required.

THE GUIDANCE

In an October 2016 entry on its website, Hardship Distribution Tips from EP Exams, the IRS advised plan sponsors that a common operational error in connection with hardship withdrawal distributions is permitting participants to make hardship withdrawals even though the plan does not specifically provide for them.

The IRS reminded plan sponsors that even if the law permits a hardship withdrawal for a specified purpose — for example, burial or funeral expenses — a plan can’t permit a distribution for this purpose unless the plan specifically so provides.

That guidance also included a warning to plan sponsors with respect to electronic hardship applications. The potential problem here is that plan participants would be self-certifying that they satisfy a plan’s hardship withdrawal criteria, allowing them to more quickly receive a distribution, but plan sponsors would still be responsible for retaining records and verifying participants satisfied hardship withdrawal requirements.

In a January 2017 website entry, the IRS said it is up to plan sponsors to track loans and hardship distributions and stated “electronic self-certification is not sufficient documentation of the nature of a participant’s hardship.”

In its interpretation of the relevant IRS regulations, while self-certification is permitted to show a distribution from the plan is the sole way to relieve a hardship, self-certification is not allowed to show the nature of the hardship. The January guidance also said plan sponsors must obtain and keep hardship distribution records.

The IRS also said it’s insufficient as a means of satisfying the record-keeping requirements for participants to keep their own records of hardship distributions. The IRS’ concern is participants may terminate employment or fail to keep copies of hardship documentation, thus making their records inaccessible during an IRS audit of the plan.

Most recently, the IRS on Feb. 23 issued a memorandum to plan examiners with respect to guidelines for safe-harbor hardship distributions from 401(k) plans.

Although an employer wishing to offer hardship withdrawals as an optional feature in its 401(k) plan may select non-safe-harbor, safe-harbor, or a combination of both types of hardship distribution, the more commonly selected alternative is the safe-harbor option.

The 401(k) regulations identify six categories of safe-harbor distribution. For each of these six categories, the guidelines specify the specific documentation required.

The guidelines also took a different view of participant involvement in documentation than did those available on the IRS website. The recent guidance indicated that if the employer or administrator received a summary of source documents such as contracts, bills and foreclosure notices, rather than the source documents themselves, the IRS examining agent should inquire whether the employer or TPA had provided a specified notification to the participant prior to making the hardship distribution.

Three of the four items on that participant notice are tax-related items: (i) the hardship distribution was taxable and additional taxes could apply; (ii) the amount of the distribution cannot exceed the immediate and heavy financial need; and (iii) hardship distributions cannot be made from earnings on elective contributions or from qualified non-elective contributions or qualified matching contributions, if applicable.

The fourth item requires the participant’s agreement to preserve source documents and make them available, upon request, to the employer or administrator, without specifying the consequences of the participant’s failure to comply with his or her agreement.

The guidance also indicated the IRS agent should be concerned if there were multiple hardship distributions in the same plan year, while recognizing these could be entirely permissible (quarterly payment of tuition, or follow-up medical or funeral expenses, for example).

Finally, if an employer or administrator is receiving summary information rather than source information from participants, the IRS examining agent is asked to determine whether the employer or administrator provides a report to the employer, at least annually, describing the hardship distributions made during the plan year.

Marcia S. Wagner is the managing and founding partner of The Wagner Law Group. She specializes in ERISA and employee benefits.