QUESTION: When participants request hardship distributions under our 401(k) plan, we collect and store documents showing that the participant had one of the immediate and heavy financial needs that are deemed sufficient to permit a hardship distribution. Could we instead allow participants to certify their needs electronically? We already use self-certification to establish that the requested distribution is necessary to satisfy the need.
ANSWER: If you carefully follow a procedure authorized by the IRS in 2017, your plan could elect to have participants provide summaries instead of the source documents that substantiate their immediate and heavy financial needs. Before outlining that procedure, let’s review the rules that led to your current practice.
A 401(k) plan can make a hardship distribution only if the participant experiences an “immediate and heavy financial need,” and the distribution is “necessary to satisfy the financial need.” The regulations expressly allow participants to self-certify that a requested distribution is the sole way to alleviate a financial need (i.e., that other resources are lacking). Or a plan could use information known to the sponsor and suspend deferrals, which relieves the plan of having to collect documentation about the participant’s lack of other resources. (Congress directed the Treasury Department to eliminate the required suspension for plan years beginning after 2018 (see our Checkpoint article).) But those strategies address only whether the distribution is “necessary,” and they do not eliminate the need to document the nature of the participant’s hardship. The informal IRS position was that a plan had to obtain certain records in paper or electronic format before making hardship distributions, including documentation substantiating the participant’s financial need. Self-certification was not considered sufficient.
In 2017, however, the IRS announced in audit guidelines that have subsequently been incorporated into the Internal Revenue Manual and IRS online resources, that plans could use a “summary substantiation method” for the six safe-harbor financial needs that are deemed sufficient to permit a hardship distribution. Under that method, participants can provide a summary of the relevant information specified for the hardship on paper, in electronic form, or in telephone records, instead of delivering source documents. To satisfy the substantiation requirements—
prescribed notifications must be given to participants regarding the source, amount, and taxation of hardship distributions;
the participant must agree to preserve the source documents and make them available upon request;
the participant must provide a complete and consistent summary of all of the required information for the claimed hardship; and
if the summary is provided to a third-party administrator (TPA), the TPA must give the employer, at least annually, a report describing the hardship distributions made during the year or access to the data.
If you use a TPA, your TPA should be able to assist you in converting to the summary substantiation method. Remember, however, that even when a TPA manages the process, the plan sponsor is ultimately responsible for ensuring that sufficient paper or electronic records are retained to support the plan’s actions in the event of an audit or dispute. In the IRS’s view, failure to adequately substantiate a participant’s financial hardship is an operational qualification failure requiring correction under the Employee Plans Compliance Resolution System (EPCRS).
For more information, including a chart of recommended supporting documents for each safe harbor hardship event, see EBIA’s 401(k) Plans manual at Section XV.G (“What Documentation Should Be Required for Hardship Distributions?”).
Contributing Editors: EBIA Staff.