United States: IRS Releases Much-Anticipated Proposed Regulations Clarifying Hardship Distribution Rules

The IRS recently released Proposed Regulations that provide much-anticipated guidance with regard to recent hardship distribution changes, which resulted due to: (1) changes made by the Bipartisan Budget Act of 2018 (the "Budget Act"); (2) changes made by the 2018 Tax Cuts and Jobs Act (the "Tax Act"); and (3) recent disaster relief guidance. The Proposed Regulations also expand upon the recent statutory changes.

Six-Month Elective Deferral Suspensions

Currently, under the "safe harbor" hardship distribution rules, a participant who takes a hardship distribution is prohibited from making future contributions to the plan (and all other employer-sponsored plans) for six months. The Budget Act made this requirement optional. As such, a plan sponsor can amend its plan to remove the "suspension requirement" beginning after December 31, 2018.

The Proposed Regulations also expand upon the Budget Act's change by allowing a plan to cover hardship distributions that were made during the second half of the 2018 plan year. For example, if a participant took a hardship distribution in September 2018, then the plan sponsor has the ability, if it so desires, to amend the plan to end the suspension period for contributions that are made on or after January 1, 2019.

Surprisingly, the Proposed Regulations would require all plan sponsors to remove the hardship suspension requirement for any distributions made on or after January 1, 2020 (i.e., the suspension period would no longer be optional).

Loan Requirement Removed

To meet the hardship distribution safe harbor rules, a participant must have taken all available plan loans. As required by the Budget Act, this requirement is removed for plan years beginning after December 31, 2018 (but, unlike the six-month suspension, will still be an optional provision).

Safe Harbor Event Modifications

Under current law, a hardship distribution can generally only be allowed if it is (1) being made due to an immediate and heavy financial need; and (2) limited to the amount necessary to satisfy such financial need. A participant is deemed to have an "immediate and heavy financial need" if such need falls into one of six safe harbor events.

The Proposed Regulations loosen the requirements as follows:

  1. Primary Beneficiary: Hardship distributions for qualifying medical, educational, and funeral expenses may now include those expenses incurred by a participant's "primary beneficiary."
  2. Federally-Declared Disasters: A new safe harbor category will be available—expenses and losses that are incurred on account of a federally-declared disaster (so long as the participant's home or principal place of business, at the time of the disaster, was located in a federally-declared disaster zone). As such, plan sponsors can now allow participants to have immediate assistance rather than waiting on the IRS or Congress to take action.
  3. Casualty Loss Clarification: Prior to the Tax Act, hardship distributions were available for expenses that were incurred to repair damage to a participant's principal residence if the damage qualified for a casualty loss deduction under Code Section 165. The Tax Act eliminated this deduction except for casualties that occurred due to federally-declared disasters. As such, many participants were ineligible to take hardship distributions during 2018 because their homes were damaged for other reasons. The Proposed Regulations offer welcome relief as they would restore the pre-Tax Act rules for casualty losses.

Reliance on Participant Representation

Currently, the determination of whether a hardship distribution is "necessary" to satisfy an immediate and heavy financial need is based upon all of the relevant facts and circumstances. The Proposed Regulations would eliminate the facts and circumstances analysis and, instead, require the participant to represent (in writing or electronically) that he or she has insufficient cash or liquid assets to satisfy the financial need. The plan administrator would then be able to rely on such representation (unless the plan administrator has actual knowledge to the contrary).

This is welcome relief because the IRS currently requires substantiation that a distribution is for one of the six safe harbors in order for it to be deemed to be on account of an immediate and heavy financial need (see our 2017 Client Alert on current IRS guidelines here.) Plans must comply with this new representation rule for any distributions that are made on and after January 1, 2020.

Sources for Hardship Distributions Expanded

As allowed by the Budget Act, the Proposed Regulations provide that hardship distributions from a 401(k) plan may include QNECs, QMACs, and the earnings on elective deferrals, QNECs, and QMACs. However, earnings on pre-tax elective deferrals to a 403(b) plan that are held in a "custodial account" are not eligible for hardship distributions.

Effective Date and Plan Amendment Deadlines

Generally, the Proposed Regulations apply to hardship distributions that are made during plan years beginning after December 31, 2018. Plans that permit hardship distributions will need to be amended to reflect these new rules once the Proposed Regulations are finalized. The deadline for amendments has yet to be determined, but the Proposed Regulations provide that plan sponsors will generally have until the end of the second calendar year beginning after the issuance of an IRS Required Amendments List that includes the new rules. However, it is recommended that plan sponsors begin amending their plans well in advance of the deadline. In addition, any plan sponsors that want to take advantage of certain changes and clarifications in 2018, will need to amend their plans before December 31, 2018.

Recent Disaster Relief

The new rules extend certain relief through March 15, 2019, to plan participants affected by Hurricanes Florence and Michael.

For more information on these changes to the hardship distribution rules, contact your SGR Executive Compensation and Employee Benefits counsel.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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