20 March 2017

Audit Guidelines for Hardship Withdrawals from 401(k) & 403(b) Plans Published by IRS

A 401(k) or 403(b) plan may permit a participant to receive an in-service distribution if the distribution is “deemed to be on account of an immediate and heavy financial need.” The IRS recently issued new audit guidelines regarding the documentation necessary to verify that this requirement is satisfied.

Background Regarding Hardship Withdrawals
IRS regulations permit both “safe harbor” and “non-safe harbor” hardship withdrawals. If certain other requirements are satisfied, a withdrawal for one of the following reasons is considered to satisfy the “safe harbor” standards:

  • Uninsured medical expenses for the participant, the participant’s spouse, children or dependents.
  • Costs directly related to the purchase of the participant’s principal residence.
  • Payment of tuition, related educational fees, or room and board expenses for up to the next 12 months of post-secondary education for the participant, the participant’s spouse, children or dependents.
  • Payments necessary to prevent the eviction of the participant from the participant’s principal residence, or foreclosure of the mortgage on the participant’s principal residence.
  • Payments for burial or funeral expenses for the participant’s deceased parents, spouse, children or dependents.
  • Expenses for the repair of damages to the participant’s principal residence that would qualify for the casualty loss deduction under the Internal Revenue Code.

The IRS audit guidelines only relate to the documentation requirements that apply to safe harbor hardship withdrawals, but are likely to also be relevant to non-safe harbor hardship withdrawals.

Background Regarding the Documentation Requirements
There has been controversy in recent years relating to the documentation required before a participant receives a hardship withdrawal:

  • The IRS historically required an employer to receive and retain source documents that justify the hardship withdrawal.
  • But some third party administrators (TPAs) permit a participant to electronically apply for a hardship withdrawal and self-certify the basis for the withdrawal.

In the April 15, 2015 issue of “Employee Plan News,” [click here] the IRS restated that employers have an obligation to receive documentation of the financial hardship before permitting a hardship withdrawal.

The New Guidelines
The IRS audit guidelines relax the documentation requirements. The employer or TPA must receive either:

  • Source documents relating to the expenses incurred under the financial hardship; or
  • A summary of the information contained in the source documents. The summary can be on paper, electronic format or telephone records.

The opportunity for an employer or TPA to receive a summary of source documents potentially allows electronic applications and participant self-certification. But, if this approach is used, some additional requirements apply:

  • The employer or TPA must provide the participant with a notice before making the hardship withdrawal. The notice must contain certain tax information. Most importantly, the participant must agree to preserve the source documents and make them available to the employer or TPA upon request.
  • If the summary of the source documents does not contain the required information, the IRS may request the source documents.
  • A TPA that receives the summaries must, at least annually, provide a report to the employer that describes the hardship withdrawals made during the year.
  • Certain additional requirements may apply if a participant receives more than two hardship withdrawals during a year.

The IRS audit guidelines also describe the type of information required to be provided for each type of safe harbor financial hardship. [click here]

MJ Comments
The IRS audit guidelines demonstrate the type of documentation that an employer or TPA must maintain to demonstrate that a hardship withdrawal qualifies under the safe harbor standards. And, fortunately, the guidelines permit electronic applications for hardship withdrawals if the additional requirements described in the guidelines are satisfied.

An employer should review its procedures for hardship withdrawals to ensure that the IRS guidelines are being followed. If a participant may apply online for a hardship withdrawal with the plan’s TPA, an employer will want to discuss with its TPA whether the TPA’s procedures will satisfy these additional requirements that apply if only a summary of the source documents is provided.

If you have any questions regarding the new IRS audit guidelines, please contact the author or any member of the Employee Benefits Practice Group.