The IRS has published a memorandum (EP memorandum) that provides IRS Employee Plans (EP) examiners with substantiation guidelines for determining whether a Section 401(k) plan hardship distribution is "deemed to be on account of an immediate and heavy financial need" under safe-harbor standards in Reg. Section 1.401(k)-1(d)(3)(iii)(B).

Background

An employee may elect to receive distributions from his or her 401(k) plan to pay expenses incurred due to certain financial hardships. Under Reg. Section 1.401(k)-1(d)(3)(iii)(B), these hardships are:

1. Deductible medical expenses for the employee, the employee's spouse, children or dependents, or the primary beneficiary under the plan

2. Costs to purchase a principal residence

3. College tuition, related educational fees, room and board for up to the next 12 months for the employee, the employee's spouse, children or dependents, or the primary beneficiary under the plan

4. Payments necessary to prevent eviction from the employee's principal residence

5. Burial or funeral expenses for the employee's deceased parents, spouse, children, or dependents or the primary beneficiary under the plan

6. Costs to repair damages to the employee's principal residence that would qualify for the Section 165 casualty deduction

In order to qualify for a hardship distribution, the employee must provide evidence substantiating the need for the distribution. The plan administrator must determine whether the hardship at issue has caused the taxpayer to incur "an immediate and heavy financial need" justifying a hardship distribution.

EP administrative guidelines

The EP memorandum outlines a two-step process for IRS personnel to follow in reviewing 401(k) distributions to determine whether they were actually made on account of an immediate and heavy financial need. If the examiner concludes that Step 1 and Step 2 are satisfied, the memorandum states that "the plan should be treated as satisfying the substantiation requirement for making hardship distributions deemed to be on account of an immediate and heavy financial need."

Step 1:

— Determine whether the employer or third-party administrator obtained appropriate substantiation (either primary source documents or a summary of information contained in these "source documents").

— If this substantiation is a summary of information, determine whether the employer or third-party administrator provides certain employee notifications before making a hardship distribution. (These employee notifications and other information are explained on Attachment I to the EP memorandum.)

Step 2:

— Review any source documents the employer or third-party administrator has obtained to determine whether they substantiate the hardship distribution.

— Review any summary of information received to determine whether it contains the relevant items listed on Attachment I.

— If any of the information is incomplete or inconsistent, request additional source documents.

— If a summary of information is complete and consistent, but employees have received two or more hardship distributions in a plan year, request source documents necessary to substantiate the distributions.

— If a third-party administrator obtains a summary of information, determine whether the administrator provides the employer with a report or other access to data, at least annually, describing the hardship distributions made during the plan year.

Attachment I details the type of information that must be included in any summary of source documents, including: (1) notifications the employer/administrator must provide the employee; (2) general information for all hardship requests; and (3) specific information required for the various hardship categories (medical care, purchase of principal residence, education expenses, foreclosure/eviction avoidance costs, funeral expenses, and repairs for damage to principal residence).

Implications

Many 401(k) plans provide the opportunity for employees to request and receive hardship distributions to provide employees the opportunity to access their 401(k) accounts for specific financial needs. Because these accounts are intended to be set aside generally for retirement and are not normally distributable until the employee separates from service or attains retirement age, however, earlier payouts of 401(k) funds jeopardize the tax-qualification of the plan trust unless a specific statutory exception is met. Hardship is one of the specific exceptions and requires the employer or another plan fiduciary to make a determination that the employee has proven the financial need.

The issuance of the EP examination guidelines indicates that hardship distributions is an area of potential IRS review in an EP examination. Many employers utilize a third-party administrator to operate their plans and it may be advisable to ensure that documentation as described in the EP examination guidelines is being retained to substantiate hardship distributions. Failure to substantiate hardship distributions could result in proposed assessments upon an IRS examination.

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