Hardship Distributions from Qualified Plans

Take-Away: New proposed Treasury Regulations may make it easier for a plan participant to take a hardship distribution from a qualified plan but only if the qualified plan permits hardship distributions to its participants.

Background: A qualified plan may permit hardship distributions (withdrawals) by participants from their account balance. The Regulations specify that a hardship withdrawal may be taken to meet an ”immediate and heavy financial need.” The amount withdrawn cannot be in excess of the amount that is necessary to actually satisfy the participant’s financial need (along with additional amounts that will be necessary to pay the income taxes on the withdrawn amount and, of course, any penalties.) [Treas. Regulation 1.401(k)-1(d)(3).] The existence of an “immediate and heavy financial need” is a determination that is made by the plan administrator. The Regulations provide examples of situations (or expenses) where there is an “immediate and heavy financial need”, and thus they provide some safe harbors that plan administrators and participants can rely upon when making a hardship distribution.

Bipartisan Budget Act of 2018: This Act, [Public Law 115-123] which followed the 2017 Tax Act, was intended, in part, to ‘clean up’ some inconsistencies created by that rushed-through tax legislation. One example was that the 2017 Tax Act substantially modified casualty loss deductions. Those prior casualty loss deduction provisions were expressly referred to in the retirement account hardship distribution Regulations that are used to identify an ‘immediate and heavy financial need,” which thus had to be modified by the 2018 Budget Act. The primary effect of the 2018 Budget Act, and hence the proposed new Treasury Regulations, was to alter some of the conditions that a plan participant had to meet in order to take a hardship withdrawal from his/her 401(k) plan account and to fall within the identified safe harbors in the Regulations.

Proposed Regulations: The proposed Regulations deal with IRC 401(k), 401(m) and 403(b). The prior Regulations contained a list of expenses that would normally qualify as an ‘immediate and heavy financial expense” for which a hardship distribution could be taken; in short,  those expenses are treated as safe harbors. While those expenses remain pretty much the same, the major change was to the conditions that the participant must satisfy in order to become eligible to take a hardship distribution.

• Future Elective Contributions: One precondition to taking a hardship distribution from a qualified plan was that the participant could not make additional contributions to any qualified plans for six (6) months after taking the hardship distribution. Probably the thinking was that if the participant faced a legitimate financial emergency then they should not be in a financial position to be able to continue to make tax deductible contributions to their qualified plan account. As such, one condition that was part of a safe harbor hardship determination was that the participant could not make elective contributions to the qualified plan for six months. This prohibition is removed under the proposed Regulations. [2018 Budget Act, Section 41113.]
• Required Plan Loans: One other precondition to taking a hardship distribution from a qualified plan was that the participant first had to take a plan loan (assuming that option was available under the qualified plan documents) before taking a hardship distribution to meet their “immediate and heavy financial need.” Again, the thinking was that if a loan could be taken to meet that immediate financial need, the need should first be met with a plan loan that could be repaid over the following 5 years. This requirement to exhaust all plan loan opportunities was also dropped in the proposed Regulations. [2018 Budget Act, Section 41114.]

Conclusion: It should be noted that a plan sponsor can impose additional conditions on a participant in the qualified plan document before they are eligible to take a financial hardship withdrawal from the qualified plan account. The above proposed Regulation changes only deal, as a generalization, with qualifying for a safe harbor expense that is identified by Treasury in its Regulations.