While the purpose of a 401(k) plan is to provide participants with the ability to save for their retirement, the Internal Revenue Service (“IRS”) recognizes the need for participants to be able to access their account balances while still employed. One of the ways a participant can accomplish this is through a “hardship withdrawal,” which can be utilized in cases of financial difficulty. It is the responsibility of the plan sponsor to verify the legitimacy of the request and to follow IRS guidelines in granting the payment.
In recent years, however, with the ability of participants to request withdrawals from the plan online through the asset custodian, sponsors have sometimes been told that there is no need to obtain this information. CPA firms, when requesting the documentation from the plan sponsor during their audit of the plan, are told, “We didn’t think we needed to have this in our files; the custodian said they would take care of everything.” When turning to the custodian for the documentation, auditors find that the documentation may also not be in their systems.
In February 2017, the IRS issued a memorandum to its agents which help defines the requirements pertaining to proper documentation and substantiation of hardship withdrawals, including detailed guidelines on information that the plan sponsor should have in its records in support of the request. It is important for plan sponsors to recognize what information they need to obtain in order to keep their plans in compliance.
A hardship withdrawal request arises, per the IRS safe-harbor definition, from an immediate and heavy financial need. The first item that should be addressed is whether the request is for a qualifying event. Qualifying events are limited to the following:
- Medical expenses not covered by insurance that would qualify as a deductible medical expense on a personal tax return.
- Costs related to the purchase of a principal residence.
- Payment for a year of post-secondary education expenses for the employee or the employee’s spouse, dependent, or primary beneficiary under the plan.
- Payment for funeral and burial expenses of a deceased parent, spouse, child, dependent, or primary beneficiary under the plan.
- Expenses for the repair of damages to a principal residence that would qualify as a casualty deduction on a personal tax return.
In order to verify one of the above, the plan sponsor must receive source documents from the participant, prior to the withdrawal, to support the request (copy of contracts, invoices, statements, or estimates). In lieu of actual documents, the plan sponsor may receive a summary of the information from the source documents; however, if a summary is provided, the participant must receive a notice explaining that (1) the distribution is taxable and additional taxes may apply, (2) the distribution cannot exceed the financial need, (3) the withdrawal can only be taken from contributions made to the plan, and (4) the recipient must agree to preserve the source documents and make them available to the plan sponsor upon request. In addition, if a participant has requested and received more than two hardship withdrawals during one plan year, the IRS memorandum indicates that, in addition to the summary, an explanation or source documents supporting multiple hardship withdrawals be obtained by the plan sponsor.
The IRS memorandum also indicates that if a third party administrator (“TPA”) prepares a summary of hardship withdrawals based on source documents, the TPA should provide the plan sponsor, at least annually, a report describing the hardship withdrawals granted during the plan year. Therefore, in performing a plan audit, steps should be taken to obtain this documentation and substantiation, as well.
The IRS has indicated that a plan qualification failure could occur if employers make hardship withdrawals without requiring and maintaining credible evidence that confirms both a valid reason for the withdrawal and the need for the amount requested. Therefore, in light of the IRS memorandum, plan sponsors should ensure that this information is available. The information should also help ensure a successful plan audit. Plan auditors should take notice of the IRS memorandum when requesting information regarding hardship withdrawals from the plan.