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401(k) Plans

Proposed regs would incorporate new law & clarify 401(k) hardship distribution rules

Thomson Reuters Tax & Accounting  

· 12 minute read

Thomson Reuters Tax & Accounting  

· 12 minute read

Preamble to Prop Regs REG-107813-18Prop Reg §1.401(k)-1, Prop Reg §1.401(k)-3, Prop Reg § 1.401(k)-6, Prop Reg § 1.401(m)-3

Proposed Regs, “Hardship Distributions of Elective Contributions, Qualified Matching Contributions, Qualified Nonelective Contributions, and Earnings”

IRS has issued proposed regs that would modify the existing rules relating to hardship distributions from section 401(k) plans. The proposed regs would reflect statutory changes affecting section 401(k) plans and would clarify a number of issues, including the impact of the Code Sec. 165(h)(5) personal casualty loss limitation in effect through 2025 on the hardship distribution rules.

Background—Sec. 401(k) plans. A profit-sharing, stock bonus, pre-ERISA money purchase, or rural cooperative plan will not fail to qualify under Code Sec. 401(a) merely because it contains a cash or deferred arrangement (CODA) that is a qualified CODA. (Code Sec. 401(k)(1))

A CODA (generally, an arrangement providing for an election by an employee between contributions to a plan or payments directly in cash) constitutes a “qualified CODA” only if it satisfies certain requirements. (Code Sec. 401(k)(2)) Contributions made pursuant to a qualified CODA (“elective contributions”) may be distributed only on or after the occurrence of certain events, including death, disability, severance from employment, termination of the plan, attainment of age 59-1/2, hardship, or, in the case of a qualified reservist distribution, the date a reservist is called to active duty. (Code Sec. 401(k)(2)(B)) Elective contributions must be nonforfeitable at all times. (Code Sec. 401(k)(2)(C))

Code Sec. 401(k)(3)(A)(ii) requires that elective contributions satisfy the actual deferral percentage (ADP) test set forth in Code Sec. 401(k)(3). Under Code Sec. 401(k)(3)(D), qualified nonelective contributions (QNECs) and qualified matching contributions (QMACs), as described in Code Sec. 401(m)(4)(C) and Code Sec. 401(k)(3)(D)(ii)(I), respectively, are permitted to be taken into account under the ADP test. QNECs and QMACs must also satisfy certain distribution limitations and nonforfeitability requirements.

Under current Reg. § 1.401(k)-1(d)(3), section 401(k) plans may provide that an employee can receive a distribution of elective contributions from the plan on account of hardship. In general, a retirement plan can make a hardship distribution only: if the plan permits such distributions; because of an immediate and heavy financial need of the employee; and in an amount necessary to meet the financial need. In general, the question of whether an employee has an immediate and heavy financial need is based on all relevant facts and circumstances. A financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee. (Reg. § 1.401(k)-1(d)(3)(iii)(A))

Under a safe harbor, Reg. § 1.401(k)-1(d)(3)(iii)(B) treats a distribution as made on account of an immediate and heavy financial need if made for one of a number of specified expenses, including those to repair damage to the employee’s principal residence that “would qualify for the casualty deduction under Code Sec. 165 (determined without regard to whether the loss exceeds 10% of adjusted gross income).”

A distribution will be deemed necessary to satisfy an immediate and heavy financial need if certain requirements are met under Reg. § 1.401(k)-1(d)(3)(iv)(E), including that, after the hardship distribution is received, the employee cannot make elective contributions or employee contributions to the plan and all other plans maintained by the employer for at least six months (6-month suspension requirement). The maximum amount that may be distributed on account of hardship is the total of the employee’s elective contributions that have not previously been distributed (plus earnings, QNECs, and QMACs credited before a specified grandfather date). (Reg. § 1.401(k)-1(d)(3)(ii))

Background—Section 403(b) annuities.  Code Sec. 403(b)(7)(A)(ii) provides distribution limitations on amounts contributed to a custodial account that is treated as a section 403(b) annuity contract. Under Code Sec. 403(b)(11), contributions made pursuant to a salary reduction agreement (“section 403(b) elective deferrals”) may be distributed only on or after the occurrence of certain events, one of which is the employee’s hardship. Code Sec. 403(b)(11) also provides that no income attributable to these contributions may be distributed on account of hardship.

Reg. § 1.403(b)-6(d)(2) provides that a hardship distribution of section 403(b) elective deferrals is subject to the rules and restrictions set forth in Reg. §1.401(k)-1(d)(3) and is limited to the aggregate dollar amount of a participant’s section 403(b) elective deferrals, without earnings thereon.

Statutory changes in BBA, TCJA, etc. There have been a number of statutory changes affecting section 401(k) plans that are not yet reflected in the regs, including:

  • . . . The Bipartisan Budget Act of 2018 (BBA; P.L. 115-123) directs IRS to modify Reg. § 1.401(k)-1(d)(3)(iv)(E), within one year from Feb. 9, 2018, to delete the 6-month prohibition on contributions and to make “any other modifications necessary to carry out the purposes of” Code Sec. 401(k)(2)(B)(i)(IV). The revised regs are to apply to plan years beginning after Dec. 31, 2018.
  • . . . The BBA added Code Sec. 401(k)(14)(A),  which states that the maximum amount available for distribution upon hardship includes (i) contributions to a profit sharing or stock bonus plan to which Code Sec. 402(e)(3) applies, (ii) QNECs, (iii) QMACs, and (iv) earnings on these contributions.
  • . . . The BBA also added Code Sec. 401(k)(14)(B),  which provides that a distribution is not treated as failing to be made upon the hardship of an employee solely because the employee does not take any available loan under the plan.
  • . . . The Tax Cuts and Jobs Act (TCJA; P.L. 115-97) added Code Sec. 165(h)(5), which, from 2018 through 2025, limits the deduction for a personal casualty loss to the extent that the loss is attributable to a federally declared disaster.
  • . . . The Pension Protection Act of 2006 (PPA; P.L. 109-280) directs IRS to modify the rules relating to hardship distributions to permit a section 401(k) plan to treat a participant’s beneficiary under the plan the same as the participant’s spouse or dependent in determining whether the participant has incurred a hardship.
  • . . . The PPA also added Code Sec. 72(t)(2)(G), which exempts certain “qualified reservist distributions” (including distributions attributable to elective contributions made during the period that a reservist has been called to active duty) from the application of the Code Sec. 72(t) additional income tax on early distributions, and Code Sec. 401(k)(2)(B)(i)(V), which permits qualified reservist distributions to be made from a section 401(k) plan.
  • . . . The Heroes Earnings Assistance and Relief Tax (HEART) Act of 2008, (P.L. 110-245) added Code Sec. 414(u)(12)Code Sec. 414(u)(12)(B)(ii) provides for a 6-month suspension of elective contributions and employee contributions after certain distributions to individuals performing service in the uniformed services.

New proposed regs. The new proposed regs would update the Code Sec. 401(k) and Code Sec. 401(m) regs to reflect these statutory changes, as described below.

The proposed regs would add an entry for “qualified reservist distributions” to the general rule in Reg. § 1.401(k)-1(d)(1), which sets out events permitting distribution of amounts attributable to elective contributions to a CODA. (Prop Reg § 1.401(k)-1(d)(1))

With respect to the regs on what constitutes a “deemed immediate and heavy financial need,” the proposed regs would  modify the safe harbor list of expenses in current Reg. §1.401(k)-1(d)(3)(iii)(B) for which distributions are deemed to be made on account of an immediate and heavy financial need by:

  1. adding “primary beneficiary under the plan” as an individual for whom qualifying medical, educational, and funeral expenses may be incurred; (Prop Reg § 1.401(k)-1(d)(3)(ii)(C))
  2. providing that, for purposes of the listed expense relating to damage to a principal residence that would qualify for a casualty deduction under Code Sec. 165, the new Code Sec. 165(h)(5) limitations don’t apply; (Prop Reg § 1.401(k)-1(d)(3)(iii)(B)(6)); and
  3. adding a new type of expense—”expenses and losses (including loss of income) incurred by the employee” on account of a FEMA-declared disaster—to the list of expenses for which distributions are deemed to be made on account of an immediate and heavy need. (Prop Reg § 1.401(k)-1(d)(3)(iii)(B)(7)) IRS described this relief as being similar to that provided to victims of Hurricane Maria and 2017 California wildfires under Ann. 2017-15 (see “Retirement plans can make loans, hardship distributions to wildfire, Hurricane Maria victims“) and is intended to “eliminate any delay or uncertainty concerning access to plan funds” following a disaster in any area designated by FEMA for individual assistance. (Preamble)

The proposed regs would also modify the rules for determining whether a distribution is necessary to satisfy an immediate and heavy financial need by:

  • . . . eliminating (1) any requirement that an employee be prohibited from making elective contributions and employee contributions after receipt of a hardship distribution (i.e., eliminating the 6-month suspension requirement), and (2) any requirement to take plan loans prior to obtaining a hardship distribution. (Preamble)
  • . . . replacing the facts-and-circumstances test in current Reg. §1.401(k)-1(d)(3)(iv)(B) with one general standard for determining whether a distribution is necessary. Under this general standard, a hardship distribution could not exceed the amount of an employee’s need, the employee must have obtained other available distributions under the employer’s plans, and the employee must represent (and the administrator may rely on this representation absent contrary knowledge) that he or she has insufficient cash or other liquid assets to satisfy the financial need. The requirement to obtain this representation would only apply for a distribution that is made on or after Jan. 1, 2020. (Prop Reg § 1.401(k)-1(d)(3)(iii))
  • . . . clarifying that a plan generally may provide for additional conditions (or, for distributions made before Jan, 1, 2020, the representation described above) to demonstrate that a distribution is necessary to satisfy an immediate and heavy financial need of an employee.  (Prop Reg § 1.401(k)-1(d)(3)(iii)(C))

The proposed regs would expand sources for hardship distributions by modifying Reg. §1.401(k)-1(d)(3) to allow plans to permit hardship distributions from section 401(k) plans of elective contributions, QNECs, QMACs, and earnings on these amounts, regardless of when contributed or earned. Safe harbor contributions made to a plan described in Code Sec. 401(k)(13) may also be distributed on account of an employee’s hardship (because these contributions are subject to the same distribution limitations applicable to QNECs and QMACs). (Prop Reg §1.401(k)-3(k)(3)(i))

With respect to section 403(b) plans, the proposed regs relating to a hardship distribution of elective contributions from a 401(k) plan would generally apply to 403(b) plans as well. However, income attributable to section 403(b) elective deferrals will continue to be ineligible for distribution on account of hardship. (Preamble)

Amounts attributable to QNECs and QMACs may be distributed from a section 403(b) plan on account of hardship only to the extent that, under Reg. § 1.403(b)-6(b) and Reg. § 1.403(b)-6(c), hardship is a permitted distributable event for amounts that are not attributable to section 403(b) elective deferrals. Thus, QNECs and QMACs in a section 403(b) plan that are not in a custodial account may be distributed on account of hardship, but QNECs and QMACs in a section 403(b) plan that are in a custodial account continue to be ineligible for distribution on account of hardship. (Preamble)

Applicability dates. The changes to the hardship distribution rules made by the BBA are effective for plan years beginning after Dec. 31, 2018, and the proposed regs would similarly apply to distributions made in plan years beginning after that date. (Prop Reg § 1.401(k)-1(d)(3)(v)(A)) However, the prohibition on suspending an employee’s elective contributions and employee contributions as a condition of obtaining a hardship distribution may be applied as of the first day of the first plan year beginning after Dec. 31, 2018, even if the distribution was made in the prior plan year.  (Prop Reg § 1.401(k)-1(d)(3)(v)(B))

In addition, the revised list of safe harbor expenses may be applied to distributions made on or after a date that is as early as Jan. 1, 2018. Similarly, a plan may be amended to apply the revised safe harbor expense relating to losses incurred by an employee on account of a disaster that occurs in 2018, provided that the employee’s principal residence or principal place of employment at the time of the disaster was located in an area designated by FEMA for individual assistance with respect to the disaster. (Preamble)

The deadlines for making plan amendments that would be required if the proposed regs are finalized are set out in Rev Proc 2016-37 , which provides deadlines for amending disqualifying provisions and other types of plan amendments (see “Determination letter program modified to end 5-year remedial amendment cycle system“). The deadline for amending disqualifying provisions is generally the end of the second calendar year that begins after the issuance of the Required Amendments List described in Section 9 of Rev Proc 2016-37, (i.e., an annually published list for changes in qualification requirements that must be made by the stated deadline) that includes the change. IRS further provided that all amendments relating to the final regs, regardless of whether or not disqualifying provisions, will have the same deadline. (Preamble)

References: For hardship distributions, see FTC 2d/FIN ¶ H-9211 et seq.; United States Tax Reporter ¶ 4014.17.

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