Hardship distribution documentation update

As an employer with a 401(k) or 403(b) plan, you have made a commitment to help your employees to save for retirement. Perhaps the last thing you want is for them to take money out of the plan before that point. But a lot of employers have chosen a plan provision that lets employees get to their savings if they experience a “hardship.” This common option can actually increase plan participation by giving employees access to their money if they have such a hardship.

The Concern

Congress created hardship distributions to help eligible individuals use plan savings to satisfy certain financial needs. The policy made sense: if people are afraid to save for retirement because they may face an emergency, let’s remove that barrier. But the rules for properly administering hardship distributions may create some of their own barriers—barriers that employers should carefully consider before approving hardship distributions. These rules are complex, so we’ll try to make them more straightforward by focusing only on what you need for proper documentation of hardship distributions.

As you might expect, some employees might request hardship distributions for situations that don’t qualify. To avoid this possibility, the hardship regulations require employers make sure that an employee truly has an “immediate and heavy financial need” before paying funds out of the plan. The rules list these “safe harbor” events that satisfy the financial need requirement.

1. Certain unreimbursed medical expenses
2. Costs directly related to the purchase of a principal residence
3. Payment of post-secondary education expenses
4. Payments necessary to prevent the employee’s eviction from or foreclosure on a principal residence
5. Certain burial or funeral expenses
6. Repair expenses for damages to the employee’s principal residence caused by qualifying events (e.g., natural disasters)

The IRS requires reasonable employer diligence in confirming whether hardship distribution requests are legitimate. Rather than taking an employee’s word for it, employers must obtain proof that a qualifying event has happened. The regulations (which, again, are complex) allow for employee self-certification in one context, but not when using the safe harbor hardship reasons above. Over the years, many employers began assuming that all that was required for a hardship payment was an employee’s certification that it was needed. This relaxed approach led the IRS to act.

The Options
To clarify the regulations, the IRS issued internal memos to its field staff early in 2017. These memos apply to audits of both 401(k) and 403(b) plans and outline the approval procedures and accompanying documentation for self-certifying hardship distributions. Employers now have two methods to document their reliance on an employee’s self-certification that an immediate and heavy financial need exists.

1. You can rely on the employee’s original source documents, including estimates, contracts, bills, and statements.
2. You can rely on a summary of source documents.

In either case, you must be prepared to provide the IRS sufficient detail to support the need for a hardship distribution. If you use the original (or “source”) documents methods, you must retain these documents to prove compliance with IRS hardship distribution rules. This would include such documents as medical, educational, or funeral home invoices, foreclosure or eviction notices, and formal estimates for home repair following a casualty loss.

If you allow your employee to provide a summary in order to obtain a hardship distribution, the summary must contain

• the employee’s name,
• the total cost of the hardship event,
• the distribution amount requested, and
• a certification by the employee that the information is accurate.

The employee must also provide specific information about the deemed hardship distribution. This information includes, for example (for medical care), who incurred the medical expense, how are they related to the employee, the general category of medical expense (e.g., diagnosis, treatment), who provided the medical service, and the amount of expense not covered by insurance.

Additionally, when you allow an employee to summarize source documents, you must give the employee a notice explaining that

1. hardship distributions are taxable and additional taxes may apply,
2. distribution amounts cannot exceed the immediate and heavy financial need,
3. hardship distributions cannot include earnings on elective contributions or from qualified non-elective contributions or qualified matching contributions, and, perhaps most important,
4. the employee “agrees to preserve source documents and to make them available at any time, upon request, to the employer or administrator.”

This last point may nudge employers away from using the summary method altogether. If you use the “summary” method and you haven’t adequately documented an employee’s financial need, the IRS will request more detailed source documents—from the employer or third-party administrator. When deciding which method to use, employers should ask themselves, “How likely is it that I will get these original documents from my employees several years after the hardship distribution?”

The Decision

The recent IRS guidance reminds us that employers are still ultimately responsible for proving that they have properly made any hardship distributions. The summary method may require you to gather proof of the hardship long after the payment; the source document method requires you to obtain the employee’s proof of hardship before you authorize a distribution. Many employers are now deciding that they are more likely to obtain the needed hardship proof if they require it from the employee up front. Most employees view hardship distribution provisions favorably—especially when they need them. Allowing such distributions may encourage some employees to contribute to their plans without worrying that they cannot get to plan assets in an emergency. Just make sure that you don’t gather the hardship documentation from your employees in a way that could create problems for you down the road.