IRS Final Rule Eases 401(k) Hardship Withdrawals, Requires Amending Plans

Changes free up funds for emergencies but could hurt workers’ savings

Stephen Miller, CEBS By Stephen Miller, CEBS September 25, 2019
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Making hardship withdrawals from 401(k) and 403(b) retirement plans soon will be easier for plan participants, and so will starting to save again following a hardship withdrawal.

On Sept. 23, the IRS published in the Federal Register a final rule that relaxes several existing restrictions on taking hardship distributions from defined contribution plans. Some of these changes are mandatory, requiring employers to make the changes by Jan. 1, 2020, while others are optional.

Unlike loans, hardship withdrawals are not repaid to the plan with interest, so they permanently reduce the employee's account balance. Hardship withdrawals also are subject to income tax and, if participants are younger than age 59½, a 10 percent early withdrawal penalty. For these reasons, withdrawals should be a last-ditch option for employees facing financial hardship.

"While many loan-takers default, at least there's a good chance that the loan will be repaid," said Aaron Tabela, chief marketing officer at Custodia Financial, which provides retirement savings loan insurance. "With hardship withdrawals, the leakage is permanent."

The IRS had issued a proposed regulation on Nov. 9, 2018, and the agency described the final regulations as "substantially similar to the proposed regulations" although some points were clarified.

What's Changing

Among its key provisions, the final rule will do the following:

• Eliminate the six-month contribution-suspension requirement.

As called for in the Bipartisan Budget Act passed in February 2018, the final rule eliminates the suspension period that barred participants who take a hardship distribution from making new contributions to the plan for six months. Starting Jan. 1, 2020, plans will no longer be able to suspend contributions following a hardship distribution.

Eliminating the contribution suspension "could have a mixed effect on leakage from 401(k) plans" by encouraging more hardship withdrawals but letting those who take distributions rebuild their savings sooner, said Lori Lucas, president and CEO of the nonprofit Employee Benefit Research Institute in Washington, D.C.

Employees often "do not continue saving for their retirement [after the six-month suspension] and often miss out on the company match," said Robyn Credico, practice leader of defined contribution consulting at Willis Towers Watson, an HR advisory firm.

• End the need to take a plan loan before a hardship withdrawal.

The new rule removes a requirement that participants first take a plan loan, if available, before making a hardship withdrawal. Unlike the elimination of the six-month suspension period, this change is not mandatory, so plans can continue to require participants to take a plan loan before being eligible for a hardship withdrawal.

"Many plan sponsors view [the loan-first requirement] as desirable, since it minimizes plan leakage," said Michael Webb, vice president at Cammack Retirement Group, a benefits consultancy in New York City.

• Make earnings available for withdrawal.

Effective in 2020, earnings on 401(k) contributions can be distributed for hardships, as can profit-sharing and stock-bonus contributions. Previously, employees could only withdraw contributions, not earnings.

Earnings on 403(b) contributions would remain ineligible for hardship withdrawals because of a statutory prohibition that Congress didn't amend.

• Ease hardship verification.

Under the rules currently in place, plan administrators must take into account "all relevant facts and circumstances" to determine if a hardship withdrawal is necessary. The new rule requires only that a distribution not exceed what an employee needs and that employees certify that they lack enough cash to meet their financial needs. Plan administrators can rely on that certification unless they have knowledge to the contrary. Plans are required to apply this standard starting in 2020.

"The IRS retained the requirement from the proposed regulations that the plan administrator may rely on the employee's representation, unless the plan administrator has actual knowledge of the contrary," Webb noted. Beginning in 2020, "an employee can make a representation that he or she has insufficient cash or other liquid assets reasonably available to satisfy a financial need, even if the employee does have cash or other liquid assets on hand, provided that those assets are earmarked to pay an obligation in the near future" such as rent, he explained.

Employee self-certifications of need for a hardship withdrawal can be made over the phone, provided that the call is recorded, the final rule clarified, or can be made in writing or by e-mail, for instance. "Plan administrators who self-administer hardship distributions may want to establish an electronic process for receiving employee representations such as through e-mail or an intranet site," attorneys at law firm Bradley advised.

"Employers didn't like figuring out when a distribution is necessary. Now there's a straightforward three-part test that covers the employer," Forbes reported, the three parts being:

  • The employee must first access other employer plan money if available, such as deferred compensation.
  • The employee signs off that he or she has insufficient cash or other liquid assets reasonably available.
  • The plan administrator signs off that he or she doesn't have any reason to believe the employee could do without the hardship withdrawal.
The requirement does not impose on plan administrators an obligation to inquire into the financial condition of employees who seek hardship distributions, noted John Lowell, an Atlanta-based partner and actuary with October Three, a retirement plan advisory firm. Rather, plan administrators only need to judge an employee's assertion to be false if the administrator "already possesses sufficiently accurate information to determine the veracity of an employee representation," as the rule puts it, rather than needing to make inquiries seeking additional information.

• Provide disaster relief.

To take a hardship withdrawal, employees currently must show an immediate and heavy financial need that involves one or more of the following: 

  • Purchase of a primary residence.
  • Expenses to repair damage or to make improvements to a primary residence.
  • Preventing eviction or foreclosure from a primary residence.
  • Post-secondary education expenses for the upcoming 12 months for participants, spouses and children.
  • Funeral expenses.
  • Medical expenses not covered by insurance.

The final rule adds a seventh safe harbor category for expenses resulting from a federally declared disaster in an area designated by the Federal Emergency Management Agency.

"Making expenses related to certain disasters a safe harbor expense is intended to eliminate any delay or uncertainty concerning access to plan funds that might otherwise occur following a major disaster," noted Nevin Adams, chief of communications at the American Retirement Association in Arlington, Va., which represents retirement plan sponsors and service providers.

According to the IRS, the agency will no longer need to issue special disaster-relief announcements to permit hardship withdrawals to those affected by federally declared disasters.

[SHRM members-only toolkit: Designing and Administering Defined Contribution Retirement]

Plan Amendments Required

401(k) plans that permit hardship distributions will need to be amended to reflect these new rules by Dec. 31, 2021, but operational changes will be needed to comply with the new regulations by Jan. 1, 2020, attorneys at law firm Proskauer pointed out. "Plan sponsors that previously took action in response to the proposed regulations should review prior plan amendments and administrative changes to confirm operational and plan document compliance with the final regulations," they added.

Adams said "the regulations note that the amendment deadline for 403(b) plans is March 30, 2020, but indicate the Treasury and IRS are considering extending that deadline for the adoption of amendments to conform to the final hardship regulations."

Joshua Rafsky, an attorney in the Chicago office of Jackson Lewis, advised that "plan administrators may also want to consider whether updates are needed to the plan's summary plan description and other communications documents that describe the plan's hardship rules, and to election forms and online election pages."

Related SHRM Articles:

Hardship Distributions Rule Reflects a Decade of Legislative Changes, SHRM Online, October 2019

Retirement Plans Are Leaking Money. Here’s Why Employers Should Care, SHRM Online, October 2017

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