401(k) employee benefit plan guidelines were established by the Internal Revenue Service (IRS) to provide an avenue for workers to set aside earnings to save for their future. To encourage employees to keep funds in their accounts, the IRS has strict guidelines governing when funds can be withdrawn from a participants’ account balance without incurring substantial fines and penalties. One option for many benefit plans is to allow for hardship distributions.
According to the IRS, a distribution is made on account of hardship only if there is an immediate and heavy financial need of the employee and the distribution is necessary to satisfy the financial need. As allowing a distribution from the plan prior to retirement goes against the original goal of saving money for retirement, the IRS requires the plan fiduciary to obtain and evaluate hardship documentation prior to approving the distribution of funds. In February 2017, the IRS released a memorandum to clarify what is required of the plan fiduciary in evaluation of the hardship request.
The memorandum clarifies that the plan is responsible for:
- determining if the distribution request qualifies for an immediate and financial need, and
- determining if the distribution is necessary to satisfy the financial need.
The IRS regulations stipulate that the following qualify as financial needs eligible for hardship withdrawal treatment:
- Medical expenses;
- Purchase of a principal residence;
- Post-secondary education expenses;
- Prevention of eviction from, or foreclosure on, a principal residence;
- Burial or funeral expenses; and
- Repair of damages to an employee’s principal residence.
The IRS memorandum clarifies that the IRS requires that the plan obtain (a) source documents (such as estimates, contracts, bills and statements from third parties); or (b) a summary (in paper, electronic format, or telephone records) of the information contained in source documents to validate that the financial need meets one of the above requirements.
If source documents are obtained, the only additional requirement of the employer or third-party administrator is to review the documents to determine if they substantiate the hardship distribution (including amount) prior to funding the disbursement. However, if a plan is going to rely on a participant summary to substantiate the financial need, there are additional procedures which need to be performed. The plan sponsor must notify the participant of additional information (taxes, allowable amount of distribution, that the recipient must preserve source documents, etc.), obtain general information regarding the situation, and obtain specific information regarding the event cited as qualifying for a hardship distribution.
In addition to qualifying for a hardship based on financial need as outlined above, the withdrawal must be “necessary to satisfy” the hardship. The distribution satisfies the necessary requirement when the participant has no other ready alternative for obtaining funds.
While the preferred method of verifying the financial need is to obtain supporting documentation from the plan participant, self-certification remains to be an allowed verification method. However, if plans elect to allow self-certifications, it is important to keep in mind there are additional requirements that must be followed for the plan to be compliance with IRS guidelines.
For more information contact your MarksNelson professional.