If your 401(k) plan recordkeeper has not talked to your company lately about hardship distributions, it may be time to reach out to the recordkeeper.  The short story is that the IRS recently issued an internal memorandum (found here https://www.irs.gov/pub/foia/ig/spder/tege-04-0217-0008.pdf) providing guidance to its employee plans examination group on the substantiation requirements for hardship distributions from a section 401(k) plan.  While this is not binding on the IRS as a statement of the law, it is useful in that it provides some indication of how the IRS would approach this issue in an audit.

By way of background, the law provides a list of expenses and costs for which a distribution would be considered on account of immediate and heavy financial need.  Historically, plan administrators and recordkeepers have struggled to find a balance between ensuring compliance with the need requirement and making the process more efficient for plan participants. A number of recordkeepers allowed participants to “self-certify” electronically and required little substantiation of the expenses, but IRS officials informally questioned whether self-certification was sufficient—most recently in a 2015 post in Employee Plans News that said plan sponsors should retain documentation and that “electronic self-certification is not sufficient documentation of the nature of a participant’s hardship.”

The latest guidance maintains the position that self-certification alone is not enough, but offers an acceptable alternative to full substantiation.

Specifically, the guidance seems to provide two substantiation options.

First, the recordkeeper could require that a participant provide full underlying documentation (or what it calls source documents) substantiating the claim, such as estimates, contracts, bills and statements from third parties.

Second, the recordkeeper could require that the participant provide a summary of the information contained in the source documents.  The summary could be in paper or electronic form or in telephone records.  But if the summary is used, there are additional requirements:

  • The summary information provided by the participant must include (i) the participant’s name; (ii) the total cost of the hardship event; (iii) the amount of distribution requested; and (iv) certification by the participant that the information provided is true and accurate.
  • The summary from the participant must also include additional information that depends on the type of hardship.  For example, for medical expense hardship, the information must include (i) the name of the person incurring the expense; (ii) the relationship to the participant; (iii) the general category of the purpose of the medical care (e.g., diagnosis, treatment, prevention, associated transportation, long-term care); (iv) name and address of the service provider; and (v) the amount of medical expenses not covered by insurance.  Each type of hardship has its own enumerated list.
  • The recordkeeper must notify the participant that (i) the hardship distribution is taxable and additional taxes could apply; (ii) the amount of the distribution cannot exceed the immediate and heavy financial need; and (iii) hardship distributions cannot be made from earnings on elective contributions or from qualified nonelective or qualified matching contribution accounts (if applicable). Of these requirements, only item (ii) is directly related to the form of substantiation.
  • The participant must also agree to preserve source documents and to make them available at any time, upon request, to the employer or recordkeeper.

In addition to the substantiation requirements, the IRS expects the recordkeeper to provide to the employer reports or other access to data on hardship distribution at least annually.

The guidance further suggests that IRS auditors might be skeptical of hardship distributions when summary documentation is used. In particular, the IRS is concerned about cases where an employee has more than two hardship distributions in a plan year.  Absent an adequate explanation (e.g., tuition on a quarterly calendar), the IRS might ask for source documents.  Auditors might also ask for source documentation if the employee’s summary is incomplete or inconsistent on its face.

The IRS’s openness to substantiation in a summary form will be welcome news to many administrators and plan sponsors. But accepting summary substantiation will require careful review by the recordkeeper and, even with that review, administrators and sponsors will have to rely on participants to maintain records.

Recordkeepers have now had a few months to process this recent guidance and react. Thus, now is a good time for plan sponsors to contact their recordkeepers to review their processes for approving hardship distributions and decide how best to proceed.  Plan sponsors should consider whether the efficiency from reduced documentation is worth the potential for headaches in an IRS audit.

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Photo of Robert Projansky Robert Projansky

Robert M. Projansky is a partner in the Employee Benefits & Executive Compensation Group and is currently a member of the Firm’s Executive Committee.

Rob has a broad practice advising both multiemployer and single employer clients on all issues related to the legal…

Robert M. Projansky is a partner in the Employee Benefits & Executive Compensation Group and is currently a member of the Firm’s Executive Committee.

Rob has a broad practice advising both multiemployer and single employer clients on all issues related to the legal compliance and tax-qualification of ERISA-covered pension and welfare plans. Rob’s clients include the largest and highest-profile U.S. media and entertainment industry clients, as well as a broad range of Fortune 500 companies.

In the multiemployer context, he serves as counsel to the boards of trustees of a number of large and small funds and frequently assists clients in addressing issues related to the funding of defined benefit pension plans, including zone status, benefit suspensions, special financial assistance and withdrawal liability. He also advises these clients on healthcare compliance, cybersecurity and government investigations. In addition, his practice includes advising corporate clients on their responsibilities related to multiemployer plans, with particular expertise on the impact of multiemployer and collectively bargained plans in corporate transactions.

Rob has extensive experience advising corporate clients regarding general compliance issues and fiduciary compliance matters, including plan asset and prohibited transaction issues. He also has addressed a myriad of issues related to complex plan investments, including negotiation of separately managed and collective investment vehicles for both traditional and alternative investments such as hedge funds, private equity funds and fund-of-funds vehicles.

Rob is described in Chambers USA as “incredibly smart and creative, and a really effective, zealous advocate” who “adroitly communicates complicated ERISA matters to clients in understandable language and well-timed levity.”  He is a widely sought after speaker on topics related to employee benefits, fiduciary, cybersecurity and government investigations and speaks each year at the annual conference and various other conferences sponsored by the International Foundation of Employee Benefit Plans, the largest educational organization in the employee benefits industry. Rob currently serves as one of the nine Advisory Directors on the Board of Directors of the International Foundation.

Photo of Seth Safra Seth Safra

Seth J. Safra is chair of Proskauer’s Employee Benefits & Executive Compensation Group. Described by clients as “extremely knowledgeable, practical, and strategic,” Seth advises clients on compensation and benefit programs.

Seth’s experience covers a broad range of retirement plan designs, from traditional defined…

Seth J. Safra is chair of Proskauer’s Employee Benefits & Executive Compensation Group. Described by clients as “extremely knowledgeable, practical, and strategic,” Seth advises clients on compensation and benefit programs.

Seth’s experience covers a broad range of retirement plan designs, from traditional defined benefit to cash balance and floor-offset arrangements, ESOPs and 401(k) plans—often coordinating qualified and non-qualified arrangements. He also advises tax-exempt and governmental employers on 403(b) and 457 arrangements, as well as innovative new plan designs; and he advises on ERISA compliance for investments.

On the health and welfare side, Seth helps employers provide benefits that are cost-effective and competitive. He advises on plan design, including consumer-driven health plans with HSAs, retiree medical, fringe benefits, and severance programs, ERISA preemption, and tax and other compliance issues, such as nondiscrimination and cafeteria plan rules.

Seth also advises for-profit and non-profit employers, compensation committees, and boards on executive employment, deferred compensation, change in control, and equity and other incentive arrangements. In addition, he advises on compensation and benefits in corporate transactions.

Seth represents clients before the Department of Labor, IRS and other government agencies.

Seth has been recognized by Chambers USA, The Legal 500, Best Lawyers, Law360, Human Resource Executive, Lawdragon and Super Lawyers.