Most 401(k) plans allow plan participants to access their retirement savings while they’re still working if they have a significant financial hardship. Recent legislation and subsequent IRS guidance have changed the rules governing these hardship distributions. As a plan advisor, you can help your plan sponsor clients understand how these changes affect their plan operations and the benefits of engaging an ERISA 3(16) fiduciary to handle implementing confusing law changes like these and other administrative tasks.
Qualifying for a Hardship Distribution
Special rules apply when participants take a hardship distribution of 401(k) plan elective deferrals. A participant must experience an immediate and heavy financial need to qualify, and the amount distributed cannot exceed the amount needed to satisfy the financial need (plus associated taxes or penalties). Most plans adopt the regulatory safe harbor definition of an immediate and heavy financial need, which limits distributions to payments for:
- Certain medical expenses of the participant, his/her spouse and dependents
- The purchase of a principal residence
- Qualified tuition and related educational fees for the participant, his/her spouse and dependents
- Preventing eviction or foreclosure on a principal residence
- Funeral expenses for the participant’s deceased parent, spouse or dependents
- Repair of certain damages to a principal residence
Most plans also adopt the regulatory safe harbor for determining the amount needed to satisfy the immediate need and heavy financial need. Under that safe harbor, the participant must first take all distributions and non-taxable loans available under all plans of the employer, and the participant’s contributions to all employer-deferred compensation plans must be suspended for six months.
If a plan does not use the safe harbor definitions, the plan administrator must determine the existence of the financial need and the amount needed to satisfy it using the facts and circumstances test.
Changes from the Bipartisan Budget Act of 2018
As a result of the Budget Act passed in February 2018, the rules for qualifying for a hardship distribution and the types of contributions available to be distributed are changing. Effective for plan years beginning on or after January 1, 2019:
- 401(k) hardship distributions can include qualified non-elective contributions, qualified matching contributions, safe harbor 401(k) contributions, and the investment earnings accrued on these types of contributions in addition to elective deferrals
- Plans may eliminate the requirement for participants to exhaust all available plan loans before qualifying for a hardship distribution
- Plans may eliminate the six-month suspension of deferrals following a hardship distribution
Guidance from Proposed Treasury Regulations
In November 2018, the Treasury Department and IRS proposed changes to existing regulations to help plan sponsors implement the changes made by the Budget Act and other recent laws affecting hardship distributions.1
- The participant’s primary beneficiary is added to the list of individuals for which medical, educational and funeral expenses qualify as an immediate and heavy financial need (for hardship distributions made on or after January 1, 2018)
- Expenses related to a FEMA-declared disaster is added to the list of the six deemed immediate and heavy financial needs (for hardship distributions made on or after January 1, 2018)
- Damage to a principal residence does not have to be in a federally-declared disaster area to qualify as an immediate and heavy financial need (as had been interpreted based on the language of the 2018 Tax Reform law)
- Plan sponsors may choose whether to require participants to exhaust available plan loans before qualifying for a hardship distribution or to eliminate this requirement in their plan (for plan years beginning on or after January 1, 2019)
- Plan sponsors may choose which of the expanded money sources will be available for hardship distributions from their plan (for plan years beginning on or after January 1, 2019)
For hardship distributions made on or after January 1, 2020, plan sponsors can no longer suspend employee contributions after granting a hardship distribution. Plan sponsors also must follow a general standard for determining whether the hardship distribution is necessary to satisfy a financial need:
- The hardship may not exceed the amount of need, plus taxes and penalties
- The participant must have obtained all other distributions available (other than loans if not required by the plan)
- The participant must represent in writing that he or she does not have the cash or liquid assets to satisfy the financial need
- The plan sponsor can rely on this representation if they don’t have actual knowledge to the contrary
The IRS will announce plan amendment requirements to incorporate these changes into the plan document after issuing final regulations.
Benefits of Engaging a 3(16) Plan Administrator
Although many of these rule changes were intended to make it easier for participants to qualify for hardship distributions and to reduce the administrative burden on the plan sponsor, keeping up to date with and implementing changes like these is a never-ending job for plan sponsors in their role as retirement plan administrators under ERISA 3(16).
Some plan sponsors may be looking for ways to shift some of the fiduciary burden of managing a retirement plan to a third party. Most plan sponsors engage a third party administrator (TPA) or recordkeeper to help them operate the plan in compliance with the many rules outlined in ERISA and the tax code. However, most TPAs and recordkeepers today serve as non-fiduciaries, leaving the ultimate responsibility and discretion for plan administration decisions, including determining whether an individual qualifies for a hardship distribution, to the plan sponsors.
In response to plan sponsor demand for ways to offload more of their administrative duties, some TPAs and recordkeepers offer a stepped-up service model by taking responsibility for fiduciary oversight and discretionary decision-making for certain aspects of plan administration, referred to as ERISA 3(16) services. One of the most common fiduciary services offered by ERISA 3(16) service providers is validating and authorizing hardship distributions, loans, and qualified domestic relations orders (QDROs). Some 3(16) plan administrators also assume responsibility for executing and filing annual returns, delivering participant notices and disclosures, and managing nondiscrimination testing, including all corrective distributions for failed tests.
Although a plan sponsor may never fully absolve themselves of their fiduciary responsibilities for administering the plan, they may see a reduced workload, reduced exposure to fiduciary liabilities, and more efficient and cost-effective management of the plan by outsourcing plan administration and management to a 3(16) plan administrator.
For your plan sponsor clients that may be looking to delegate some or all of their plan administration responsibilities, you can serve as a gateway to ERISA 3(16) service providers that provide the scope of administration and fiduciary support your client wants. You can also provide benchmarking assistance to help them weigh the value of services provided against the fees charged.
When Newport Group acts as the 3(16) plan administrator, we manage some of the day-to-day operation of the plan, including hardship distributions. For more information, contact your Newport Group representative.
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1 IRS, Treasury, Hardship Distributions of Elective Contributions, Qualified Matching Contributions, Qualified Non--elective Contributions, and Earnings, 26 CFR 1, 83 FR 56763, November 14, 2018, https://www.federalregister.gov/documents/2018/11/14/2018-24812/hardship-distributions-of-elective-contributions-qualified-matching-contributions-qualified
Withdrawals and distributions of taxable amounts are subject to ordinary income tax, and if taken before 591/2, may be subject to a 10% federal tax penalty.
Newport Group and its affiliates do not provide tax, legal and accounting advice. You should consult your own tax, legal and accounting advisors before making any decisions. 20190313-749119-2377359