By Jeremy T. Rodriguez, JD
In mid-November 2018, the IRS issued proposed regulations altering some of the rules governing hardship distributions from 401(k) and 403(b) plans. Most of the rules weren’t new; instead the IRS adopted changes that were issued in previous pieces of legislation, such as the Tax Cuts and Jobs Act, the Bipartisan Budget Act of 2018, and the Disaster Tax Relief and Airport/Airway Extension Act of 2017. The key takeaway from the proposed regulations is that the IRS has continued to chip away at some of the restrictions imposed by the tax code on hardship distributions.
One of the changes eliminated the rule that participants first obtain a plan loan before requesting a hardship distribution. The restriction did have some good sense behind it: the initial loan distribution isn’t subject to withholding or the early distribution penalty and the entire transaction is tax-free if properly repaid. Hardship distributions are not subject to withholding either, but they are always taxable and subject to the 10% early withdrawal penalty. Despite this, many people did not want to deal with loan repayments, especially on small distributions. Others couldn’t make repayments within the time required timeframe (such as those with casualty losses), and the rule was poorly enforced among plans.
Therefore, the requirement no longer applies for plan years beginning January 1, 2019. However, if you are eligible for a regular distribution, you must take that before requesting a hardship distribution. This makes sense for the participant since hardship distributions are limited to the expense. They can be grossed up for local, state, or federal taxes, but other than that no additional amount can be taken. In fact, you may have to provide documentation to prove the expense. There are also the federal tax implications mentioned above.
On the other hand, you can take any amount in a regular distribution, use what you need, and rollover any excess. There’s no need to justify the distribution. The only downside is that any amount of the regular distribution that is payable to you (i.e., not directly rolled over) is subject to 20% withholding.
Another change eliminated the 6-month suspension of salary deferrals following a hardship distribution. The effective date is the same (i.e., plan years beginning January 1, 2019), but here plans have an option. First, lets talk about the rule. The old rule forced plans to stop accepting salary deferrals for a full 6-month period following the date a participant received a hardship distribution. This prevented someone from receiving employer matching contributions that would’ve been made during the suspension period. And just like the other restriction discussed above, it was poorly enforced among plans.
However, for this rule, plans have a choice: they can stop applying the suspension for everyone, even on hardship distributions taken before January 1, 2019, or they can stop the suspension only for hardship distributions issued on or after January 1, 2019.
Example: Andrew received a hardship distribution on October 1, 2018 to pay for his daughter’s college education expenses. His 401(k) plan immediately suspended his ability to make salary contributions. The original 6-month period is set to expire on April 1, 2019. The plan is a calendar year plan. Andrew’s plan can continue the suspension until that time or lift all suspensions as of January 1, 2019. If the plan lifts all suspensions, Andrew would be able to resume making salary contributions to the plan as of January 1, 2019
Finally, the proposed regulations also created a new hardship category for expenses and losses suffered in a federal disaster area. This additional category is added to the safe harbor list as of January 1, 2019 (calendar year plans) but can be adopted all the way back to the beginning of 2018 to accommodate victims of Hurricanes Michael and Florence. Going forward, victims of future disasters that participate in plans that allow hardship distributions will be able to request a distribution without having to wait for Congressional relief.
Quite clearly, the new rules lessen some of the negative implications that followed hardship distributions. The disaster category is especially important to anyone affected by a major disaster, since it can take months to settle an insurance claim. However, hardship distributions are optional, and plans do not have to allow them. If your plan doesn’t offer hardship distributions, consider making a written request to the plan sponsor. While the plan doesn’t have to accept all requests, ERISA rules require a thorough review and a detailed written response to the participant explaining the plan’s ultimate decision.