New guidance released for IRS field auditors in February of this year indicates that more extensive documentation requirements will be required for 401(k) plans offering hardship distributions.
To qualify for the hardship distribution, the participant must show that the hardship event occurred and that the 401(k) distribution was necessary to meet the financial need.
The IRS “safe harbor” list of hardship events includes:
- Purchase of participants primary residence
- Unreimbursed medical expenses sustained by the participant or certain family members
- Tuition expenses of the participant or certain family members
- Payment to prevent the participants imminent foreclosure or eviction from their primary residence
- Funeral expenses for certain family members
- Repair expenses to the participants primary residence due to qualified casualty loss
Confirming that a participant qualifies for the hardship is clearly necessary. In the past, the IRS permitted this through attestation by the participant that no other assets existed to meet the need. However, what has been considered proper attestation or certification of the hardship and financial need varied from plan to plan and from employer to employer. The new guidance creates conformity and prevents employers from being in the position of reviewing and judging the financial position of its employees.
The new guidance requires that the employer or third party administrator, prior to making the hardship distribution, obtain documentation of the hardship. Documentation may be in one of two forms. The first would be source documents that include medical or repair bills, tuition invoices, contracts or escrow documents. The second would be a summary of information from source documents. With either approach, sufficient detail must be present to support the need for the hardship distribution.
If the summary approach is taken, the employee must provide the summary of the hardship and expenses and certify that the information provided is true and accurate. Additionally, the plan sponsor and/or administrator must provide the employee with the following facts:
- The hardship is taxable and additional taxes could apply.
- The amount of distribution cannot exceed the immediate financial need.
- Hardship distributions cannot be made from earnings on elective contributions or from QNEC or QMAC accounts, if applicable.
- The recipient must agree to preserve source documents and to make them available at any time, upon request, to the employer or administrator.
The guidance issued to IRS field auditors was effective February 23, 2017 and clearly states that the new procedures apply to any open audits. For plans not already requiring source documents or summary information to be provided, it may be valuable to request from participants who have taken hardship distributions during open examination years to produce the source documentation or at least a summary. This may mitigate some of the potential risk from open years and bring the plan as close to retrospective compliance as possible.
Note: the statute of limitations on IRS examinations for a given plan year is three years after the filing of the Form 5500 in relation to that year.