401(k) Plan Sponsors – Time to Revisit Your Hardship Withdrawal Provisions

by Verrill Dana LLP
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The Bipartisan Budget Act of 2018 (“Budget Act”) includes several changes to the rules governing hardship withdrawals from 401(k) plans.  Because the changes apply to plan years beginning after December 31, 2018, 401(k) plan sponsors should start considering their options now and make decisions regarding which changes, if any, to implement to allow plenty of time to develop and timely distribute participant communications, update procedures and re-program plan administrative systems (including coordination with the plan recordkeeper’s systems), and amend their plan documents.

Key Changes Made by the Budget Act

The Budget Act includes the following changes:

1. It amends Section 401(k) of the Internal Revenue Code (“Code”) to permit the withdrawal of the following amounts, in addition to elective deferrals, in the event of hardship:

-  qualified nonelective contributions ("QNECs")
-  qualified matching contributions ("QMACs")
-  safe harbor contributions (other than QACA safe harbor contributions that are subject to a vesting schedule)
-  earnings on the above contributions and on elective deferrals 

None of these amounts (other than pre-1989 earnings on elective deferrals) are available currently for a hardship withdrawal.

2. It amends Code Section 401(k) to provide that a participant is not required to take any available loan under the plan before taking a hardship withdrawal.

Of note, the Budget Act does not expressly direct the Secretary of the Treasury to eliminate the loan requirement from the safe harbor under the regulations for deeming a withdrawal to be necessary to satisfy a participant’s immediate and heavy financial need.  As explained below, the Budget Act does, however, direct the Secretary to modify the regulatory safe harbor as “necessary to carry out the purposes of [the statutory hardship withdrawal provision].”  It is likely the regulation will be modified to remove the loan requirement for consistency with the new statutory provision.

3. It directs the Secretary of the Treasury to modify the safe harbor under the regulations to (i) eliminate the 6-month suspension period for making elective deferrals (pre-tax or Roth) or employee after-tax contributions to the plan (and all other qualified and nonqualified plans of deferred compensation, as well as stock option, stock purchase or similar plans, maintained by the employer) after receipt of the hardship withdrawal, and (ii) make any other modifications necessary to carry out the purposes of the statutory hardship withdrawal provision.

The Secretary of the Treasury has until February 9, 2019 to modify the regulatory safe harbor for deeming a withdrawal to be necessary to satisfy a participant’s immediate and heavy financial need.

None of the changes are mandatory (with the possible exception of eliminating the 6-month suspension period in order for a plan to retain its regulatory safe harbor status and any other changes that the Secretary of the Treasury may make to the requirements for the regulatory safe harbor).

Open Questions (Pending IRS Guidance)

IRS guidance is needed now to help answer numerous questions that have been raised by 401(k) plan sponsors about the changes, especially those plan sponsors whose 401(k) plans utilize the regulatory safe harbor described above and whose plans are safe harbor design plans for purposes of ADP/ACP nondiscrimination testing.  As these plan sponsors know, changes to a safe harbor design plan for a plan year generally need to be adopted before the first day of that plan year; otherwise, if the change affects the required content of the annual notice of safe harbor design and is adopted after the start of the plan year, an updated notice reflecting the change will need to be timely distributed.

The questions include:

  • Will a plan be treated as satisfying the regulatory safe harbor if it retains the 6-month suspension period for purposes of making elective deferrals and employee contributions?
  • What happens to participants whose 6-month suspension period has not yet expired when the change to eliminate the suspension period becomes effective?
  • Will a plan be treated as satisfying the regulatory safe harbor if it retains the requirement that a participant must first obtain any available plan loan before taking a hardship withdrawal?

Hardship Withdrawal Changes Plan Sponsors Should Consider

There is no guarantee that the Secretary of the Treasury will modify the regulatory safe harbor (or that the IRS will issue any guidance) by year end.  While we await official guidance, here are some recommendations and observations for plan sponsors to consider in deciding which of the hardship withdrawal changes, if any, to adopt.

1. Do not allow participants to request a hardship withdrawal of QNECs, QMACs, or safe harbor contributions (and any earnings thereon). 

We make this recommendation for one simple reason: to prevent retirement plan leakage.

2. Allow participants to request a hardship withdrawal of all earnings (i.e., post-1988 earnings too) on elective deferrals.

Retirement plan leakage needs to be weighed against simplifying plan administration (including interactions with participants regarding the dollar amount available for a hardship withdrawal), and, here, we think simplifying plan administration wins out.

3. Retain (at least until we have official guidance) the requirement that a participant first obtain a plan loan before taking a hardship withdrawal.

Again, we make this recommendation to guard against retirement plan leakage.  However, once we know what the modifications to the regulatory safe harbor will be, plan sponsors may need to revisit this decision point (i.e., preventing retirement plan leakage may need to be weighed against retaining safe harbor status for hardship withdrawal purposes).

4. Eliminate the requirement to suspend elective deferrals and employee contributions for six months after receipt of a hardship withdrawal.

We make this recommendation because it will not create a compliance issue with the regulatory safe harbor, as modified, and because we think most immediate and heavy financial needs (e.g., down payment on the participant’s principal residence, a tuition payment, or medical care expenses) do not result in putting the participant in a position where he or she cannot afford to continue making elective deferrals or employee contributions after the withdrawal.

5. Take a look at your nonqualified deferred compensation plans.

The directive from Congress to the Secretary of Treasury to eliminate the 6-month suspension period from the regulatory safe harbor has implications for nonqualified deferred compensation plans too.  It is common for these plans to provide that if a nonqualified plan participant receives a hardship withdrawal from the qualified 401(k) plan, his or her nonqualified plan deferral election will be cancelled for six months (or the remainder of the plan year in which the hardship withdrawal is made, if longer).  If a plan sponsor decides to amend its 401(k) plan to eliminate the 6-month suspension period following a hardship withdrawal, it also may wish to amend its nonqualified deferred compensation plan(s) to eliminate the cancellation requirement following the hardship withdrawal.

6. 403(b) plan sponsors should wait for clarifying guidance before expanding the sources available for a hardship withdrawal.

The regulations under Section 403(b) of the Internal Revenue Code state that a hardship withdrawal from a 403(b) plan has the same meaning, and is subject to the same rules and restrictions, as a hardship withdrawal under the 401(k) regulations.  Thus, if the rules and restrictions under the 401(k) regulations change, the change also would apply to hardship withdrawals from 403(b) plans (e.g., elimination of the required 6-month suspension period from the 401(k) regulatory safe harbor also would apply to 403(b) plan hardship withdrawals).  However, what if the change to the 401(k) hardship withdrawal rules was a change to the statute and not the regulations, like the change to Code Section 401(k) to expand the sources available for a hardship withdrawal?  While Congress may have intended that the new sources available for 401(k) plan hardship withdrawals be available for 403(b) plan hardship withdrawals too, Code Section 403(b) appears to prohibit this.  Specifically, Code Section 403(b)(11) states that a 403(b) plan annuity contract may not provide for the distribution of any income attributable to a participant’s elective deferrals in the case of hardship.  This statutory provision was not modified by the Budget Act.  A technical corrections bill from Congress or clarifying guidance from the IRS is needed for 403(b) plan sponsors to proceed with certainty before implementing this change.

7. Reminder – Expenses for the repair of damage to a participant’s principal residence not attributable to a federally declared disaster are no longer deemed to be an immediate and heavy financial need.

The 401(k) regulations identify six “safe harbor” immediate and heavy financial needs, one of which is expenses for the repair of damage to the participant’s principal residence that would qualify for the casualty deduction under Code Section 165 (determined without regard to whether the loss exceeds 10% of adjusted gross income).  Effective for casualty losses incurred in taxable years beginning after December 31, 2017, and before January 1, 2026, the Tax Cuts and Jobs Act of 2017 amended Code Section 165 to limit casualty loss deductions to those attributable to a federally declared disaster.  By cross-referencing the casualty loss deduction rules under Code Section 165, the safe harbor for expenses for the repair of damage to the participant’s principal residence became more narrow as of January, 2018 because expenses for the repair of damage that is not attributable to a federally declared disaster are no longer eligible for a hardship withdrawal (at least not under the safe harbor).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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