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On November 14, 2018, IRS proposed amendments to current 401(k) hardship withdrawal rules, implementing changes made by the Bipartisan Budget Act of 2018 (BBA 2018), providing a new and more flexible hardship withdrawal “safe harbor” and expanding the amounts that may be withdrawn from a 401(k) plan in a hardship withdrawal. The new rules would be generally effective in 2019.
In this article, we briefly review current rules and then discuss IRS’s proposal.
Under current rules, in a 401(k) plan, generally (and subject to some exceptions), amounts “attributable” to 401(k) elective deferrals may not be distributed earlier than severance from employment, death, or disability.
The Internal Revenue Code provides an exception to this rule for distributions “upon hardship of the employee.” Under the regulations the maximum hardship distribution is, however, limited to the amount of a participant’s actual 401(k) contributions, without taking into account earnings, QNECs or QMACs.
IRS regulations break the hardship distribution analysis into two separate issues: (i) the distribution must be on account of an “immediate and heavy financial need;” and (ii) it must be “necessary to satisfy [that] financial need.”
With regard to issue (i), the regulations provide a list of “deemed immediate and heavy financial needs,” including, e.g., “costs directly related to the purchase of a principal residence.” Let’s call this the “deemed need” rule.
With regard to issue (ii), under IRS regulations, a distribution is “treated as necessary to satisfy an immediate and heavy financial need” if the employee (1) makes a representation that the amount is necessary (provided the employer does not have actual knowledge to the contrary), (2) has obtained all available distributions and nontaxable loans under all plans of the employer; and (3) is prohibited from making contributions to all employer plans for at least 6 months (the “6-month holdout” rule). Let’s call this the “treated as necessary” rule.
IRS’s proposal would make changes both to the “deemed need” and the “treated as necessary” rules and expand the kinds of contributions/earnings that may be withdrawn in a hardship withdrawal.
With respect to the “deemed need” rule, IRS’s proposal would make three relatively limited changes:
A participant’s primary beneficiary would be included in the persons for whom hardship-qualifying medical, educational, and funeral expenses may be incurred.
The “damage to a principal residence” deemed hardship would not be limited by certain limitations on casualty losses added by 2017 tax reform legislation.
A new deemed hardship would be added for expenses resulting from certain federally declared disasters.
The changes to the “treated as necessary” rule are generally more significant. In place of the current rule (which as noted requires that the participant take all available loans and cease contributions for 6 months), under the proposal a participant may take a hardship withdrawal if two conditions are satisfied:
The participant must take all other available distributions under employer plans (qualified or nonqualified); and
Beginning in 2020, the employee must make a representation “that he or she has insufficient cash or other liquid assets to satisfy the need.” Absent actual contrary knowledge, the plan administrator may rely on this representation. For distributions in 2019, however, a plan may require this representation, “to demonstrate that a distribution is necessary to satisfy an immediate and heavy financial need of an employee.” Thus (it appears) this representation would function as a safe harbor in 2019; for 2020 and after, it is required for any hardship withdrawal.
Generally, the plan may impose greater restrictions on hardship withdrawals, e.g., the plan could continue to require that the participant take all available loans. Beginning in 2020, however, the plan may not require that the participant suspend contributions as a condition of taking a hardship distribution.
Finally, the proposal would eliminate the limitation of a hardship distribution to a participant’s 401(k) contributions, thereby allowing distributions that include earnings, QNECs, and QMACs.
Except where noted, the new rules generally apply to distributions made in plan years beginning after 2018. There are several exceptions to this rule: As noted, plans may continue to apply contribution suspension rules in 2019. For distributions made in the second half of 2018, the plan may allow contributions to begin January 1, 2019. And the changes to the “deemed need” rules may be applied in 2018.
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The new rules are generally good news, providing for an easier-to-administer and more flexible set of hardship withdrawal rules while also allowing sponsors to impose more stringent rules (other than with respect to the suspension of contributions) where they deem appropriate.
Comments on the proposal are due by January 14, 2019.