On Sept. 23, the IRS published a final rule that relaxes several existing restrictions on participant 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. Though the IRS had issued the proposed regulations in 2018, the final regulations clarify a few key provisions:
- The Loan-First Rule. The new rule removes the requirement that participants exhaust their ability to take a loan from the plan before being granted a hardship. This provision is not mandatory as some plan sponsors view the “loan first” requirement as helpful to participants. Unlike participant loans, hardships permanently reduce a participant’s balance and are subject to income taxes and a 10% early withdrawal penalty if participant is under age 59 1/2. So, taking a loan first may be in the participant’s best interest.
- The Six-Month Rule. Starting January 1, 2020, plans will no longer be required to suspend participant salary deferral elections following a hardship distribution. Prior to the final rule, the inability for the participant to continue contributing to the plan and the lost opportunity to receive matching contributions further compounded the leakage from a participant’s account caused by the withdrawal.
- More withdrawal sources available. Effective in 2020, earnings on 401(k) plans are available for hardship distributions as well as safe harbor or profit-sharing contributions.
- Disaster Related Expenses. The new rule adds a seventh category as an acceptable reason for a hardship withdrawal. Disaster related expenses for an employee who lived or worked in a federally declared disaster area is now a safe harbor category that automatically counts as a hardship withdrawal. The other six acceptable hardship reasons are:
- Medical care expenses for the participant, his/her spouse, dependent, or beneficiaries,
- Costs directly related to the participant’s purchase of his/her primary residence (not including mortgage payments),
- Amounts necessary to prevent the participant’s eviction from, or foreclosure on, the participant’s primary residence,
- Funeral expenses for the participant, his/her spouse, dependents, or beneficiaries,
- Tuition expenses (fees, room and board, etc.) for the next 12 months of post-secondary education for the participant, his/her spouse, dependents, or beneficiaries,
- Expenses incurred to repair damage or make improvements to the participant’s primary residence. Repairs must fall under the IRS’s description of a casualty loss. Damages must be sudden, unexpected or unusual and cannot be from progressive deterioration (normal wear and tear).
- Showing Financial Need. Under the rules currently in place, employers and 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.
For plan sponsors who use “pre-approved” plan documents for their 401(k) plans, the due date to amend your plan for the new regulations is the same as the tax filing deadline (including extensions) for the year in which the provisions become effective. For example, if the new rule is effective on January 1, 2020 for a plan sponsor with a calendar fiscal year, the due date for amending the plan is the due date of the plan sponsor’s 2020 return including extensions. Regardless of the amendment date, compliance must begin on January 1, 2020. For those who maintain individually designed plans, the deadline will be December 31, 2021 regardless of plan year.
Plan Sponsors that took action on the proposed regulations should review their plan and operational processes to ensure compliance with the new rules and can contact us with any questions.
This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.
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