Sponsors of 401(k) plans are permitted, but not required, to allow participants to withdraw funds from their 401(k) account if the participant incurs a qualifying hardship. In order to qualify, a participant must have an immediate and heavy financial need and the amount must be necessary to satisfy the need.
Original safe harbor provisions
Many plan sponsors adopted safe harbor provisions to meet each of the hardship tests. Under the provisions, a participant is considered to have an immediate and heavy financial need if a withdrawal is necessary to:
- Prevent eviction or foreclosure
- Purchase a primary residence
- Pay qualifying education expenses
- Pay funeral costs
- Pay medical expenses not covered by insurance
- Pay certain expenses to repair damage to the participant’s principal residence
A plan is not required to follow the safe harbor provisions and, instead, could adopt its own facts and circumstances tests to determine if a participant has an immediate and heavy financial need to warrant a qualified distribution. Given the additional administrative burdens in administering a plan without safe harbor provisions, most plans follow the safe harbor provisions (or a slightly modified safe harbor approach).
The amount available for a hardship withdrawal is limited to the total of the participant’s elective contributions (including contributions to a Roth IRA) as of the date of the distribution and is reduced by prior distributions of elective contributions. The amount available does not include earnings on the elective deferrals (unless certain earnings were grandfathered) or qualified nonelective contributions (QNECs) or qualified matching contributions (QMACs).
Withdrawal provision updates
The Bipartisan Budget Act of 2018 (BBA) contained several changes to the hardship withdrawal provisions that should reduce some of the administrative burdens related to hardship withdrawals. The BBA:
- Amends Section 401(k) to allow hardship withdrawals to include QNECs, QMACs, and earnings on elective deferral contributions
- Directs the U.S. Department of the Treasury to amend regulations to remove the required six-month suspension period following a hardship withdrawal
- Amends Section 401(k) to allow hardship withdrawals without regard to whether a participant first obtained available loans from the plan and any other plans maintained by the employer
- Plans are permitted to eliminate the six-month suspension period for plan years beginning on or after Jan. 1, 2019. The suspension must be eliminated for hardship withdrawals made during plan years beginning on or after Jan. 1, 2020. Plans also are permitted to eliminate suspensions that are in place as of Dec. 31, 2018, so the suspension on a hardship withdrawal taken in the second half of 2018 can be cut short as of Jan. 1, 2019.
- While the BBA provides that QNECs and QMACs can be distributed as a hardship withdrawal, there was a question as to whether the provision also included QNECs and QMACs made by safe harbor 401(k) plans. The proposed regulations clarify that QNECs or QMACs made to a safe harbor 401(k) plan are permitted to be distributed in a hardship withdrawal.
- The BBA eliminates the need for a participant to take available loans before taking a hardship withdrawal. The proposed regulations eliminate this requirement (although plans are permitted to keep it). Additionally, for any hardship withdrawal on or after Jan. 1, 2020, a participant must provide written representation that they have insufficient cash to satisfy the financial need. The plan administrator may rely on the representation absent actual knowledge that the representation is not true.
- The regulations also expand the safe harbor circumstances permitting a hardship withdrawal to include medical, education, or funeral expenses of primary beneficiaries. In addition, the proposed regulations continue to permit plans to deem a participant eligible for a hardship withdrawal for expenses related to the repair of a principal residence that qualifies for the casualty loss deduction under IRC Section 165, without regard to the change made by the Tax Cuts and Jobs Act (TCJA). The TCJA limits the deduction of casualty losses only if such losses are attributable to a federally declared disaster. The proposed regulation clarifies that expenses incurred to repair damage to a principal residence will be allowed even if the damage is not attributable to a federally declared disaster.
Plan sponsors using individually designed plan documents should work to determine any amendments needed in order to implement any optional changes for 2019, as well as any required and optional changes for 2020. Sponsors using a preapproved document such as a volume submitter or prototype plan document should have heard from their document sponsor about amending for optional provisions in 2019. In most cases, preapproved document sponsors currently are preparing amendments for the 2020 required and optional changes and should communicate with plan sponsors on these items later this year.