New IRS regulations make hardship distributions from 401(k)s easier
Do you have clients who administer 401(k) plans for their businesses, or do you have clients who need quick cash to get through a financial pinch? Recent updates to the rules for hardship distributions make it easier to tap into those funds in an emergency. Business owners who sponsor a 401(k) plan will need to update their plan documents to incorporate these changes.
What stays the same?
Overall, the rules stay the same: 401(k) account owners can take a hardship distribution when they have an “immediate and heavy financial need” and have no other readily available financial resources. Safe harbor distributions are allowed for the following types of expenses:
- Medical expenses
- Purchase of a home
- To prevent eviction or foreclosure
- Funeral expenses
- Higher education
- Damage to a home
As before, hardship distributions become taxable income, and may also be subject to a 10 percent early withdrawal penalty if the account owner is under 59 ½. The plan participant must also be a current employee of the plan sponsor.
What are the changes?
The new regulations clarify that damage to a home is not restricted to the updated definition of deductible casualty losses contained in tax reform. This means the damage need not be caused by a federally declared disaster. However, expenses resulting from a federal disaster have been added as a seventh category of safe harbor expenses. In this situation, the funds must be for the benefit of the plan participant who must live within the federal disaster zone.
Employees are no longer required to suspend contributions to a 401(k) account for six months following a hardship distribution. In the past, many employees failed to restart contributions after the six months was up, so this move will help keep workers on track for consistent retirement saving.
Recipients must first exhaust all other allowable distributions from their accounts, but they no longer need to take out a loan from their 401(k) before requesting a hardship distribution.
Under the old rules, plan administrators had to evaluate the facts and circumstances of a person’s situation before granting a hardship distribution. That open-ended investigation has been replaced with a simple three-prong test:
- The plan participant must first take all other available distributions from their plan.
- The participant signs off that no cash or readily available funds are available to meet an immediate and heavy financial need.
- The plan administrator signs off that they don’t currently possess any information contradicting what the plan participant says.
The request for funds needs to be in writing or in electronic format. The new regulations note that email and recorded phone calls satisfy the electronic format requirement.
The total amount of the allowable distribution has been clarified. The total can’t exceed the amount needed to satisfy the financial need, However, the distribution may include enough to cover related taxes and penalties. In addition, the definition of “readily available funds” excludes cash already earmarked to cover other expenses such as rent.
When are the changes effective?
Plan administrators have until the end of 2021 to amend plan documents. However, they must comply with the changes by January 1, 2020. Starting with plan years beginning after Dec. 31, 2018, plan administrators may eliminate the six-month suspension of contributions following a hardship distribution. This same date can also be used as an optional effective date for the updated definitions of allowable expenses and the requirement that plan participants first take out loan from their 401(k).
Is a hardship distribution better than a loan?
Unlike a loan from a 401(k), hardship distributions don’t need to be repaid. However, withdrawing funds will permanently reduce the principal amount available for growth and future distributions. Loans can be repaid over five years, so if this is a short-term cash crunch, a loan may be the better option. If an employee leaves before the loan balance has been repaid, the outstanding amount will be treated as a distribution.
Whether you have clients who administer 401(k) plans for their employees or whether you have clients who need to tap the funds in their 401(k)s, being aware of these changes will help you be a trusted advisor!