Over the years, hardship distributions have proven to be a valuable source of cash for employees facing immediate and heavy financial burdens; and under the Department of Treasury’s Income Tax Regulations, as long as hardship distribution requests were substantiated, safe harbor distributions are available for:
- Medical care for the employee, the employee’s spouse, children or other dependents.
- The purchase of a principal residence.
- Payment of tuition, related educational fees, room and board expenses for up to the next 12 months of post-secondary education for the employee, the employee’s spouse, children or other dependents.
- Payments that are deemed necessary to prevent the eviction of the employee from their principal residence or to stop the foreclosure of the mortgage on their primary residence.
- The burial or funeral expense for the employee’s deceased parents, spouse, children or other dependents.
- The repair of damages to the employee’s principal residence that would qualify for a casualty deduction.
However, plan sponsors and Third Party Administrators (TPAs) have been without access to a structured set of guidelines to help them adequately substantiate the claims – until now.
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The IRS recently provided plan sponsors and TPAs of 401(k) and 403(b) plans with substantiation guidelines to help govern when plan hardship distributions can be dispersed. The guidance ultimately reiterates the importance of adhering to your plan document while stressing the importance of always making an effort to dot your ‘i’s’ and cross your ‘t’s.’
The two-step administrative process is as follows:
Step 1 – Determine whether source documents, including estimates, contracts, bills and statements from third parties, or a summary of the information contained in said source documents was obtained and used to make a decision with regard to the disbursement of a hardship distribution.
Summaries can take the form of a paper or electronic document or telephone records. If a summary of the information found on the source documents was used, before the distribution is made, the employer or third-party administrator must notify the employee that:
- The hardship distribution is taxable and additional taxes could apply.
- The amount of the distribution cannot exceed the immediate and heavy financial need.
- Hardship distributions cannot be made from earnings on elective contributions or from QNEC or QMAC accounts, if applicable
- The recipient agrees to preserve source documents and to make them available at any time, upon request, to the employer or administrator
Step 2 – Once received, the employer or TPA must thoroughly review the documents to determine whether the hardship distribution was adequately substantiated. If a summary of information was given, the employer or TPA must be able to, at minimum, answer the questions found on Attachment I of the memorandum, which are required to substantiate the claim.
For example, if an employee is making a hardship distribution request for repairs of damage to their principal residence, the summary must include the address of the residence that sustained damage, whether or not the residence in question is the employee’s principal residence, a description of the cause of the casualty loss, the date the casualty loss occurred and a description of the repairs needed and whether the repairs were completed (and the date when they were completed) or if they are in the process of completing the repairs.
Note: If the notifications that were provided to employees or the substantiation of information is incomplete or inconsistent, you have the right to ask for source documents that substantiate the need. Or, if the employee does provide you with complete and consistent information, but they have already received more than two hardship distributions within the plan year, then, “in the absence of an adequate explanation for the multiple distributions and with managerial approval, you may ask for the source documents from the employer or third-party administrator to substantiate the distributions.” This may apply to follow-up medical expenses or tuition on a quarterly school calendar, for example.
Finally, the employer should receive a report or access to data, at least annually, that describes the hardship distributions made during the plan year.
According to the memorandum, if the applicable requirements in the steps outlined above are satisfied, then the IRS will likely determine that you’ve met your substantiation requirement. If you’ve failed to meet these steps, you may have a few headaches you’ll need to prepare to answer for.
Not sure if your plan is in compliance? Have additional questions? Email the retirement plan services team at Rea & Associates for assistance.
By Andrea McLane, QKA (Dublin office)
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