IRS final rule delivers easier access to 401(k) hardship withdrawals
Thursday, October 17, 2019
On Sept. 23, the Internal Revenue Service (IRS) published a final rule that simplifies hardship withdrawals for 401(k) and 403(b) plan participants.
The final rule substantially mirrors the IRS’ proposed regulations — reflecting changes made by the Tax Cuts and Jobs Act of 2017, the Bipartisan Budget Act of 2018, the Pension Protection Act of 2006, and the Heroes Earnings Assistance and Relief Tax Act of 2008.
Some changes are optional; others are mandatory and must be implemented by Jan. 1, 2020.
Mandatory Changes for 401(k) Plans
Removal of the six-month suspension.
Participants who take a 401(k) hardship withdrawal must currently wait six months to start making contributions again. Under the final rule, employers can no longer impose a six-month waiting period on participants who take hardship distributions.
Many industry veterans have advised against hardship withdrawals, arguing that such transactions result in 401(k) plan leakage — meaning, the money is prematurely disbursed and causes a reduction in the participant’s retirement savings. This reduction occurs because, unlike 401(k) loans, hardship withdrawals do not have to be repaid and are not subject to interest.
Some observers expect the removal of the six-month suspension to have a varied impact on 401(k) plan leakage — noting that it will encourage more hardship withdrawals while enabling the participants who take them to start saving again sooner.
Relaxation of the “financial need” standard.
Based on the present rules, employers must consider all the relevant facts and circumstances when determining whether a participant needs a hardship distribution. The final rule streamlines this process by creating one general standard.
Under the general standard, the hardship withdrawal amount cannot exceed what the employee needs. Further, the employee must certify that he or she does not have enough cash or liquid assets to meet the financial need.
Employers can rely on the employee’s certification, unless they have knowledge that contradicts the certification.
Optional Changes for 401(k) Plans
Termination of plan loan requirement.
Presently, 401(k) participants must exhaust all available plan loans before making a hardship withdrawal. The final rule removes this condition, deeming it optional.
This means that employers can continue requiring that participants take all available 401(k) loans first. Or, they can permit participants to skip the loan and go straight for the hardship withdrawal — providing no other withdrawals are available to the employee under the employer’s plan.
Employers concerned about 401(k) plan leakage can simply keep the loan-first stipulation in place.
Expansion of sources for hardship withdrawals.
Prior to the new regulations, hardship withdrawals could be taken only from elective contributions. Thanks to the final rule, employers can permit hardship withdrawals to be dispersed from elective contributions, qualified non-elective contributions, qualified matching contributions, and earnings on these amounts.
Provision of disaster relief.
To qualify for a hardship withdrawal, participants must currently show that they have an “immediate and heavy” financial need. The IRS defines the expenses that constitutes “immediate and heavy,” such as certain medical expenses and burial or funeral costs.
The final rule broadens the list of “immediate and heavy” expenses to include costs associated with a federally declared disaster in a location designated by the Federal Emergency Management Agency (FEMA).
Next Steps for Employers
If your 401(k) plan allows hardship withdrawals, you must adopt the mandatory changes by Jan. 1, 2020.
However, the deadline for amending plan documents depends on the type of 401(k) plan. Employers with an individually designed 401(k) plan have until Dec. 31, 2021 to amend their plan documents. Those with a pre-approved 401(k) plan have until their 2020 tax-filing deadline, including extensions, to make amendments.
Collaborating with your 401(k) providers in a timely manner is essential to achieving compliance and a smooth transition.
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