Maintaining 401(k) Plan Hardship Documentation Just Got Easier – Or Did It?
The IRS has updated its guidelines on what auditors should review regarding 401(k) hardship distributions – a very common subject of IRS examinations. In recent years, the IRS has required the plan to maintain source documents justifying hardship distributions. The new Memorandum for Employee Plans (EP) Examinations Employees (“Memorandum”), dated February 23, 2017, provides that participants, instead of the plan, can maintain the hardship documentation as long as certain requirements are met. But is it a good idea to rely on participants to preserve their hardship documentation?
Overview of 401(k) Plan Hardship Distributions
Generally, a 401(k) plan may allow hardship distributions if the following requirements are met: (1) the plan document allows the specific type of hardship distribution; (2) the participant has an “immediate and heavy financial need” due to one of the specified hardship events; and (3) the distribution is necessary to meet the financial need.
Section 401(k) plan regulations provide six safe harbor events that are deemed to meet the second requirement of “immediate and heavy financial need” if they are properly substantiated: medical care, purchase of principal residence, payment of tuition and expenses, payments necessary to prevent eviction or foreclosure, burial or funeral expenses for certain family members, and expenses for the repair of damages to the employee’s principal residence. A plan can also allow hardship distributions for non-safe harbor events, but most plans limit hardships to these six safe harbor reasons.
Substantiating Safe Harbor Hardship Reasons
Historically, plans could approve a hardship distribution only if participants provided documentation to support the hardship, such as a death certificate and funeral home bill to establish the hardship need for payment of burial and funeral expenses. In recent years, the IRS has taken the position that a participant cannot “self-certify” that the hardship exists – the plan must verify and maintain the documentation of the hardship. The IRS specifically called out the common third-party administrator process of electronic self-certification, whereby participants would simply certify online the need for the hardship and that all requirements were met.
Some third-party administrators have continued to process hardship distributions via self-certification, which has created problems for plan sponsors during IRS audits. In examinations, the IRS has required plans to produce sufficient documentation to show the hardship distribution was appropriate. If the IRS discovers an improper hardship distribution on examination, the IRS typically requires the plan to attempt to recover the improperly paid amount, and the IRS may impose a sanction on the plan sponsor due to the plan operational error.
Under the new Memorandum, a form of electronic self-certification of the hardship is allowed, provided certain requirements are met. Plans no longer have to collect and keep source documents that justify a hardship claim. Instead, plans may obtain a summary of the participant documentation that would otherwise be required, with the caveat that the employer may need to request the actual source documents from participants at a later date. Plans must maintain the summary, which can be in paper, electronic, or telephone format.
The Memorandum also describes what specific information plans must collect and summarize for each of the safe harbor hardship reasons. For example, required information for an educational hardship distribution includes the name of the student, relationship to the participant, name and address of the educational institution, categories of educational payments involved and periods covered by the payments. Each summary also requires a participant certification that the information provided is true and accurate.
The summary method can only be used if the plan provides a notification to the participant of the following:
The hardship distribution is taxable and additional taxes could apply;
The amount of the distribution cannot exceed the amount of the need;
Hardship distributions cannot be made from earnings on elective contributions or from QNEC or QMAC accounts (if applicable); and
The recipient must agree to preserve the applicable source documents and to make them available to the plan administrator upon request.
Finally, it appears that if the summary method is used, the third-party administrator must provide a report at least annually to the employer, describing the hardship distributions during the plan year.
If the plan is audited by the IRS and the agent feels that either the employee notification, the summary of hardship information, or the employer report is incomplete, the IRS may ask for source documents. The plan sponsor would then have to obtain the source documents from the participant in order to prove that the distribution was proper. The IRS also may ask for the source documents if the auditor finds an employee with more than two hardship distribution in a plan year without an adequate explanation in the summary (e.g., there could be a second hardship distribution for a second tuition payment).
Next Steps for Plan Sponsors and Administrators
Plan sponsors should consider whether it makes sense to implement the new substantiation method. There are risks with this method: how practical is it that the participants will actually maintain the documentation, and that even if they do, the plan sponsor would be able to obtain the documentation from the participant at a later date? Participants may no longer be employees at the time of an IRS audit. The Memorandum provides that source documents would only be required if the notification or summary is incomplete, so it appears that if the plan sponsor has strong processes and documentation in place, then no source documentation should be required. Therefore, any plan sponsors that wish to take advantage of the new summary method should work with their TPAs and ERISA counsel to ensure that all requirements are met. They will need to prepare summaries for each type of hardship with all required information, the notification to employees, and a hardship report to the employer. If TPA services change, plan sponsors may need to modify services agreements with their TPAs.
Furthermore, all plan sponsors, even if they do not want to use the new method, should take this opportunity to review their hardship procedures and document maintenance in light of the Memorandum’s specific guidance on documentation required for each type of hardship and requirements for self-certification.