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Agency changes its position from 2015 informal guidance, requires employees to keep own documentation
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Employees no longer routinely have to provide their employers with documentation proving they need a hardship withdrawal from their 401(k) accounts, according to the Internal Revenue Service (IRS). Employees do, however, need to keep source documents, such as bills that resulted in the need for hardship withdrawals, in case employers are audited by the IRS, the agency said.
Due to uncertainties in how the IRS would handle audits, conservative employers may still choose to require employees to provide source documentation even before audits, said Marcia Wagner, an attorney with The Wagner Law Group in Boston.
In recent years, many institutions administering the records for 401(k) accounts have allowed employees to report on the account administrator's website that they have a hardship and need to make a withdrawal, without requiring them to submit documentation or bills to show why they need the money, noted Brenna Clark, an attorney with Eversheds Sutherland in Atlanta. But if those 401(k) plans were audited, IRS agents would ask the employers for proof that the withdrawals were due to hardships. Agents did not think the self-certification electronic policy was enough, Clark said, and expected these third-party record-keepers or employers to have copies of the bills that gave rise to the hardship withdrawals.
In 2015, the IRS issued a newsletter saying that employers should ask for and keep physical proof of the need for hardship withdrawals, such as medical bills. An employee providing a summary of the cause for withdrawal on the third-party record-keeper's website was not enough, she noted.
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But in a Feb. 23 memorandum to IRS agents, the agency changed its position on the documents needed to substantiate a hardship withdrawal, Wagner said. "Previously, the IRS would be looking for source documents to substantiate a hardship withdrawal," she said. "But the new guidance permits the use of a summary of the information contained in the source documents."
Under this guidance, to rely on a summary of information, the third-party record-keeper or employer needs to send the employee a notice that requires the employee to agree to preserve the underlying source documents (e.g., bills) and make them available at any time upon the request of the employer or third-party record-keeper.
Source documents for these specific hardship withdrawals should note: Medical care
Purchase of principal residence
Foreclosure/eviction from principal residence
Funeral and burial expenses
Repairs for damage to principal residence
"If any of those items was omitted from the summary, the summary would be incomplete," Wagner observed.
Be careful of inconsistencies such as a medical service invoice for services after a funeral date or an expense for a casualty loss prior to the date of the casualty, she noted. "In these circumstances, the agent will ask the employer or the TPA [third-party administrator] for the source documentation. This is where a potential risk exists for the employer and why the IRS has in the past been reluctant to accept self-certification."
The information may have been lost or misplaced or the employee no longer works for the employer by the time the audit is conducted years later. "It is unclear from the memorandum what action the agent would take in this circumstance, and it might depend upon how serious the incomplete or inconsistent summary was," she noted.
Employees Should Keep Documentation
Employers and third-party record-keepers should at the very least make it clear to the employee that he or she should keep physical proof of the need for the hardship withdrawal and make the proof available at any time on request by the employer, Clark said. If employers are allowing employees to take more than two hardship withdrawals a year, they might require physical proof up front rather than waiting for an IRS audit, she added. Or an employer could limit employees to two hardship withdrawals a year.
Some employers prefer for employees to have unlimited access to their accounts, she noted. However, other plans prefer to help employees to keep their money in the plan and grow it for retirement. The difference in treatment comes down to employers' philosophy toward hardship withdrawals, Clark said.
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