Houston, We Have a Problem…

Times can get tough for people. With the onset of Hurricane Harvey having decimated parts of the Gulf Coast and Hurricane Irma following its destructive lead, we are reminded that at any point we may find ourselves in hardship. Companies make layoffs, natural disasters occur, emergencies… well, emerge. With nowhere else to turn, some will look to their 401k for their own disaster relief. A withdrawal in the form of a “hardship distribution” is one of the tools that participants may use in this situation. This year the IRS released new examination guidelines for documenting hardships. Their intent is to clarify the documentation process of proving the existence of a hardship and verifying that the amount withdrawn did not exceed the actual financial need.

Before we go into the regulations surrounding a hardship withdrawal, it is important to define what a hardship is. A hardship distribution is a withdrawal from a participant’s retirement account made because of an immediate and heavy financial need. It is limited to the amount necessary to satisfy that financial need but may include amounts required to pay the taxes and penalties. While living conditions and lifestyle choices differ for everyone, the government has created a universal list of events that may cause undue financial strain. The list includes:

Qualifying medical expenses.
Costs related to a principal residence (But not mortgage payments).
Tuition.
Prevention of eviction.
Burial or funeral expenses.
Repair of damages to principal residence (Especially important during hurricane season).

Does your plan allow for hardship distributions? This is an important question to consider as the plan sponsor and if the answer is yes, there are certain responsibilities you must undertake to justify the withdrawal from your plan’s assets. Many 401(k) plans allow for hardship withdrawals since it is generally believed to encourage participation levels. Participants seem more at ease knowing that they could access their accounts in the event of an immediate financial need.

So, how does a participant justify and their employer verify that the withdrawal amount of a hardship requested complies with the regulations? The IRS regulations require that the plan administrator obtain source documents (or a summary of that information), issue the required employee notifications that accompany a hardship withdrawal, and verify they meet the hardship requirements.

So, how have things changed? Historically, to keep employers from being in a position of reviewing the employee’s financial situation or judging how critical their hardship need is, the participant was able to demonstrate their hardship through an “attestation”. While it was understood that if audited the participant would have to produce the proof, problems producing that proof arose at times, especially when the participant was no longer available. This left the plan in a precarious position with distributions not being justified or not for the proper amount. However, a participant attesting to the fact that they need a hardship distribution isn’t enough to move forward anymore. Difficulty in verifying the need and the appropriate distributable amount was simply leading to too many problems.

How does one avoid trouble with a hardship in an audit? Two words… source documents. Auditors will look for documentation supporting the event like receipts, medical bills, tuition expenses, contracts, or a summary of these examples, and they can be provided electronically. The recipient also must agree to keep these documents and be able to produce them upon request if needed (say… for an audit). This documentation is critical and especially helpful in instances where the employee has moved on.

The second key step in the guidelines is disclosure. You must provide the employee who requests a hardship with all pertinent tax and possible withdrawal penalty information. It also needs to be made clear exactly what can be taken as a distribution and from what sources. Depending on the source of the funds, different rules apply to the participant’s ability to make a withdrawal and will be outlined in the plan documents.

If you’ve been going about hardships in this fashion, keep going, you’re doing great. If you haven’t and your plan offers them, tighten up your procedures moving forward. While hardship withdrawals from retirement savings should be a participant’s last resort, they have increased every year over the last five years and that trend is likely to continue. Your familiarity and efficiency in relation to the process will help participants navigate otherwise stormy seas.

This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.