The cost of administering 401(k) plans has decreased steadily over recent years, in part due to the efficiencies gained through technology. Electronically processing hardship distributions has been a challenge, however, because of the fact-based nature of the determinations plans must make. Although many providers, including the largest and most well-known, have used online, participant self-certification to process hardships, serious questions remain whether this process is adequate—and the employer, not the provider, remains responsible for any improper hardships. Recent changes to IRS audit guidelines for its examiners indicate the IRS may be more flexible than in the past, as long as certain notice and documentation requirements are met.
The ability to defer taxation by contributing current income to a 401(k) plan comes with some strings attached. One is that access to the deferred amounts is strictly limited during employment. Allowing early access to 401(k) funds can disqualify the entire 401(k) plan for tax purposes. If the participant experiences a heavy and immediate financial need, however, and the participant’s other resources are insufficient to satisfy that need, the 401(k) plan can make an in-service distribution to the participant—as long as the plan terms allow it.
The IRS has established safe harbor rules that plans can use to ensure the hardship requirements are met. These rules, used by most 401(k) plans, provide a list of events that qualify as a heavy and immediate financial need, such as medical expenses and home purchases, and presume other resources are insufficient if all other loans or other distributions available from other plans of the employer are taken and deferrals are suspended for six months. The challenge arises from making sure the event cited by the participant is legitimate. For example, was the expense for a home purchase and was it for the participant’s primary residence?
Until now, the IRS has required the plan to have documentation showing that the expenses support the need cited. Electronic self-certification has been problematic both because the plan did not obtain or retain the documents required and because no one was checking to see whether the documentation supp-orted the hardship.
New IRS Safe harbor Hardship Substantiation Guidelines
The new “Guidelines for Safe Harbor Distributions from Section 401(k) Plans” (Guidelines) for Employee Plans Examinations employees, appear to loosen the strict documentation requirements. The Guidelines allow a summary of the relevant documents to be provided and maintained in the records in lieu of the actual documents, as long as the participant:
- Receives advanced notice explaining the requirements and taxation of hardship distributions; and
- Agrees to preserve the source documents and make them available on request.
The summary must specifically detail how the requirements are met. In addition, the provider must give an annual report, or access to data, to the employer describing the hardship distributions made during the plan year.
These seem like fairly straightforward requirements that could be met through an electronic process. However, the process could still be problematic on a couple of fronts.
First, the summary of documentation and factual representations must support the hardship being requested. If there is no human being on the receiving end looking at exactly how the questions are answered and the list of documentation, the hardship could be processed even though the summary is insufficient. Because the providers do not consider themselves fiduciaries, they generally do not want to exercise any discretion in reviewing hardship distributions.
This has already been a problem for several clients of ours, including even those with large, well-known providers. In a sample of ten hardships we reviewed for one client, eight were insufficient based on the self-certifications made. In another case, our client, who reviewed the hardships itself, realized a strange, repetitive consistency in the foreclosure notices provided with the hardship requests and discovered an internal employee manufacturing foreclosure notices for other employees. This would not have been caught under an electronic summary process.
Second, even if everything looks consistent and complete, if one participant receives more than two hardships in any plan year, the Guidelines instruct the examiner to further investigate and ask for the actual documents to substantiate the distribution. Further documentation may not be required, however, if there is an adequate explanation. An example of an adequate explanation would be where follow-up medical expenses were necessary or where tuition is paid for a college on a quarter, rather than semester, system.
If you are processing your own hardship distributions and requiring actual documentation, and you are comfortable with the process, then you should maintain that process. If you either rely on your provider to process hardship distributions or would like to hand off that responsibility to your provider, we recommend that you:
- Expressly limit hardships to no more than two per year;
- Ask your provider whether it is using the actual documentation or summary document process and have them document that process for you;
- Audit a sample of hardship distributions to ensure that the process chosen is being followed and that the hardship distributions are justified by and consistent with the documents or summary provided by the participant; and
- Review and document your review of data or reports provided to you as required under the summary process, if the provider is using that process. This review ideally should be conducted during your regular committee meetings.
If you would like to have assistance with reviewing your provider’s hardship determination process or have any other questions about hardship distributions, please feel free to contact me or your Warner Norcross & Judd attorney.