On February 23 and March 7, 2017, the Internal Revenue Service (“IRS”) issued memoranda to examination agents addressing review of substantiation provided in support of safe harbor hardship distributions under 401(k) and 403(b) plans. Although the memoranda cannot be relied upon as official guidance, they are good reference points to help plan sponsors and third party administrators (“TPAs”) avoid issues on audit.
401(k) and 403(b) plans may allow hardship distributions on account of immediate and heavy financial need of an employee that cannot be satisfied from other sources, including plan loans. The Treasury Regulations provide a safe harbor for certain distributions that — if properly substantiated — will be deemed to be on account of an immediate and heavy financial need, including:
• medical care for the employee or the employee’s spouse, children or dependents;
• purchase of a principal residence;
• payment of tuition, related educational fees, room and board expenses for up to the next 12 months of post-secondary education for the employee or the employee’s spouse, children or dependents;
• payments necessary to prevent eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence;
• payments for burial or funeral expense for the employee’s deceased parents, spouse, children or dependents; or
• expenses for the repair of damages to the employee’s principal residence that would qualify for a casualty deduction.
In reviewing safe harbor hardship distributions, auditors will review source documents — such as estimates, contracts, bills and statements from third parties — or a summary of the information contained in the source documents. The memoranda’s reference to review of a “summary of information” seems to contemplate — and signal tacit approval of — electronic or streamlined hardship distribution processes, pursuant to which requests do not include submission of source documents, but rather require only the employee’s certified representation concerning the content of, and a promise to preserve, the source documents.
Summary of Information
In order to avoid potential unpleasantries on audit, plans that use an electronic or streamlined hardship distribution request process will need to take certain steps. First, the employer or TPA must provide the employee notice that, inter alia, the distribution is taxable, cannot exceed the immediate and heavy financial need, cannot be made from earnings on elective deferrals and — perhaps most importantly — the employee must agree to preserve the underlying source documents and make them available at any time upon request of the employer or TPA. Second, the summary of information must include, at a minimum, the information specified in the memoranda required to substantiate the hardship distribution in question — for example, a hardship distribution request for funeral expenses should include the name of the deceased, the deceased’s relationship to the employee, the date of death and the name and address of the service provider of the funeral or burial. Third, if a TPA administers hardship distributions, it should provide a report to the employer at least annually that describes the hardship distributions made during the year.
Where a summary of information is incomplete or inconsistent on its face, the auditor may ask the employer or TPA for the source documents. In addition, where an employee has received more than two hardship distributions in a plan year, in the absence of adequate explanation — such as follow-up funeral expenses — and with IRS managerial approval, the auditor may ask to review source documents.
Recommended Next Steps
Review your plan’s hardship distribution procedures and, if applicable, confer with your TPA to ensure compliance with the memoranda. Although the memoranda cannot be relied upon as binding authority, conforming your hardship distribution procedures should go a long way to helping you complete a successful hardship distribution audit.