By Robert J. Parton
Qualified Plan Administrator
In February 2017, the Internal Revenue Service (IRS) issued an internal memo to its audit staff concerning hardship distributions and the documentation necessary for a Plan Sponsor to keep on file proving that the hardship distribution satisfies an immediate and heavy financial need. Before we go into the back up needed, let’s review what a hardship distribution is and what the IRS deems legitimate reasons for a plan participant to take a hardship distribution.
A hardship distribution is a type of in-service distribution that a defined contribution plan may allow a participant with an immediate and heavy financial need. As with all distribution types, the plan document will outline if a hardship distribution is allowed by the plan. The IRS states that a participant may take a hardship distribution, assuming the plan allows hardship distributions, if the distribution is due to an immediate and heavy financial need and is limited to the amount necessary to satisfy the financial need.
A distribution is automatically considered to be necessary to satisfy an immediate and heavy financial need if all of the following requirements are met:
- The distribution isn’t greater than the amount of the immediate and heavy financial need, including the amounts necessary to pay any taxes resulting from the distribution.
- The participant has obtained all other currently available distributions (including distribution of ESOP dividends under section 404(k), but not hardship distributions) and nontaxable (at the time of the loan) plan loans, including all other plans maintained by the employer.
- The participant isn’t allowed to make elective deferrals to the plan for at least six months after the hardship distribution.
The IRS details six “safe harbor” reasons that automatically qualify as an immediate and heavy financial need:
- Unpaid medical care expenses for the participant, the participant’s spouse, dependents or primary beneficiary.
- Costs directly related to the purchase of a participant’s principal residence (excluding mortgage payments).
- Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the participant or the participant’s spouse, children, dependents or beneficiary.
- Payments necessary to prevent the eviction of the participant from the participant’s principal residence or foreclosure on the mortgage on that residence.
- Funeral expenses for the participant, the participant’s spouse, children, dependents, parents, or beneficiary.
- Certain expenses to repair damage to the participant’s principal residence that qualify for a casualty deduction.
A hardship distribution is limited to the amount due, plus taxes, for the above safe harbors and cannot exceed the outstanding balances. It is the Plan Sponsor’s responsibility to certify that the participant requesting a hardship is, in fact, only requesting enough funds to pay for the outstanding bills and that the participant has exhausted all other sources of money, including loans from their retirement plan account. The Plan Sponsor can rely on the participant’s written statement that they cannot obtain the requested amounts from other sources unless the Plan Sponsor knows that this is contradictory to the actual situation. If the Plan Sponsor deems that the participant taking a loan for their plan account will create additional hardship for the participant, the participant will not need to obtain a plan loan prior to the hardship distribution.
The internal IRS memo from February 2017 reiterated the previous definition of a hardship distribution and details what that the Plan Sponsor must obtain and keep certifying that the hardship distribution was an immediate and heavy financial need. The Plan Sponsor can either keep source documents (statements, bills, contracts, etc.) of the immediate and heavy financial need or a summary of the information provided in the source documents. If Plan Sponsors decide to keep a summary of the source documents, there are now detailed and required pieces of information that they must keep on file and a notice that the participant must receive.
If the Plan Sponsor uses a summary of source documents, the participant must receive a notice with the following:
- Hardship distributions are taxable and additional taxes may apply.
- Distribution amounts cannot exceed the immediate and heavy financial need.
- Hardship distributions cannot be made from earnings on elective contributions or from qualified nonelective contribution (QNEC) or qualified matching contribution (QMAC) accounts, if applicable.
- Distribution recipients must agree to preserve source documents and to make them available at any time, upon request, to the employer or administrator.
In addition to the notice to the participant taking the hardship distribution, the Plan Sponsor’s summary of source documents must contain the following:
I. General Information for All Hardship Requests
- Participant’s name
- Total cost of the event causing hardship (total cost of medical care, total cost of funeral/burial expenses, payment needed to avoid foreclosure or eviction, etc.)
- Distribution amount requested
- Certification by the participant that the information provided is true and accurate
II. Specific Information on Deemed Hardships
- Medical Care
- Name of the individual who incurred the medical expenses
- Relationship to the participant (self, spouse, dependent, or primary beneficiary under the plan)
- Purpose of the medical care (not the actual condition but the general category of expense, such as diagnosis, treatment, prevention, associated transportation, long-term care)
- Name and address of the service provider (hospital, pharmacy, doctor/dentist/chiropractor, etc.)
- Amount of medical expenses not covered by insurance
- Purchase of Principal Residence
- Whether this will be the participant’s principal residence
- Address of the residence
- Purchase price of the principal residence
- Types of costs and expenses covered (down payment, closing costs, title fees, etc.)
- Lender’s name and address
- Date of the purchase/sale agreement
- Expected date of closing
- Educational Payments
- Name of the individual the educational payments are for
- Relationship to the participant (self, spouse, child, dependent, or primary beneficiary under the plan)
- Name and address of the educational institution
- Categories of educational payments involved (post-high school tuition, related fees, room and board)
- Period covered by the educational payments (beginning/end dates of up to 12 months)
- Foreclosure/Eviction from Principal Residence
- Whether this is the participant’s principal residence
- Address of the residence
- Type of event (foreclosure or eviction)
- Name and address of the party that issued the foreclosure or eviction noticeDate of the notice of foreclosure or eviction
- Due date of the payment to avoid foreclosure or eviction
- Funeral and Burial Expenses
- Name of the deceased
- Relationship to the participant (parent, spouse, child, dependent, or primary beneficiary under the plan)
- Date of death
- Name and address of the service provider (cemetery, funeral home, etc.)
- Repairs for Damage to Principal Residence
- Whether this is the participant’s principal residence
- Address of the residence that sustained damage
- Brief description of the cause of the casualty loss (e.g., fire, flooding, type of weather-related damage), including the date of the casualty loss
- Brief description of the repairs, including the dates of repair (in process or completed)
The IRS states that it is the Plan Sponsor’s fiduciary responsibility to have the necessary supporting documentation above, but how does this actually affect Plan Sponsors and Plan Auditors? Now that the IRS has notified, in detail, what is required for hardship distribution support, Plan Sponsors will need to provide the information if they are under audit by the IRS and presumably the Department of Labor (DOL). This information will also be needed as supporting documentation during the annual plan audit by an independent public accountant.
Issues with self-certification
An issue that will only increase with the continued growth of online processing is the self-certification by participants online that their hardship distribution meets the IRS’s regulations. Currently, this occurs more with defined contribution plans that have their services “bundled” (custodian, recordkeeping, and TPA services are with one service provider) than with those that have these plan services with more than one service provider. Service providers providing bundled services currently have some checks in place for self-certification by participants; however, they do not require the documentation that is now required by the IRS. This is an issue for Plan Sponsors because they are unable to show independent public accountants or IRS/DOL auditors the documentation that is now mandatory. The IRS has explicitly responded to self-certification and its validity as documentation. Per the IRS’s website, “electronic self-certification is not sufficient documentation of the nature of a participant’s hardship. IRS audits show that some TPAs allow participants to electronically self-certify that they satisfy the criteria to receive a hardship distribution. While self-certification is permitted to show that a distribution was the sole way to alleviate a hardship, self-certification isn’t allowed to show the nature of a hardship.”
With the IRS stating that it is the Plan Sponsor’s fiduciary responsibility to keep specific records for hardship distributions, the self-certification online by participants can be troubling. Plan Sponsors should require participants who self-certify to provide them with the necessary documentation so that the Plan and the Plan Sponsor can be compliant with the IRS’s new stance.
The buck stops here
The IRS’s new hardship documentation requirements render the Plan Sponsors the sole responsible party to ensure that hardship distributions are an immediate and heavy financial need and are limited to the amount necessary to satisfy the financial need. Plan Sponsors may need to change their current policies to comply with the additional supporting documentation requirement. Independent public accountants will have to update their audit procedures for hardship distributions and may need to educate Plan Sponsors who are not aware of the new IRS requirements. The IRS’s February 2017 memo detailed the required documentation necessary for hardship distributions in the case of an IRS audit and stated that it is the Plan Sponsor’s fiduciary responsibility to maintain these records. This change will need to be implemented immediately by Plan Sponsors to ensure that they are compliant with IRS regulations.