On February 23, 2017, the Internal Revenue Service (“IRS”) issued a Memorandum to IRS agents. The Memorandum identified the steps agents should take, in examining a 401(k) plan, to confirm that a hardship withdrawal is “deemed to be on account of an immediate and heavy financial need” under safe-harbor standards. This Advisory summarizes that Memorandum.

Background

Over the past few years, the IRS has provided informal guidance regarding the requirement for substantiation and documentation of hardship withdrawals from a 401(k) plan. The IRS Memorandum provides additional guidance on what documents meet the substantiation and documentation requirements under the safe-harbor rules.

Hardship Withdrawals

Generally, 401(k) plans may provide that an employee can withdraw his or her elective contributions prior to termination of employment on account of hardship. In order to prove a hardship, the withdrawal must be made on account of an immediate and heavy financial need of the employee (or dependent or, in some places, a beneficiary of the employee). Hardship withdrawals can be made to pay for medical care expenses, costs related to the purchase of a principal residence, and payments needed to prevent eviction or foreclosure from the employee’s principal residence. Most, but not all, plans impose the IRS “safe-harbor criteria” for administering hardship withdrawal requests, under which, specific requirements must be met.

Substantiation Requirements

Substantiation is required to confirm that a hardship withdrawal is on account of an immediate and heavy financial need. According to the Memorandum, an IRS agent will take the following steps when reviewing a safe-harbor hardship withdrawal:

1. Determine whether the employer or third-party administrator (“TPA”), prior to making a withdrawal, obtains source documents (such as estimates, contracts, bills, or statements from third parties) or a summary (see description below) of the information contained in the source documents.
2. If a summary is used, determine whether the required notifications (described below) are provided to the employee before making the hardship withdrawal.
3. Review the documents to determine if they substantiate the hardship withdrawal.

The documentation must be complete and consistent on its face and, generally, an employee should not have received more than two hardship withdrawals in a plan year, for the plan to be treated as satisfying the substantiation requirement. If not, the IRS agent should request source documents (if a summary is provided) or adequate explanation from the employer or TPA to substantiate the withdrawal.

In the absence of official source documents (such as bills, statements, etc.), the employee may be allowed to provide the employer or TPA a summary of the information contained in the source documents. The summary should describe the event causing the hardship and the total cost of the hardship, and contain a certification by the employee that the information provided is true and accurate. Depending on the event, the details may vary, but the following should be included for:

1. Medical Care Expenses – name of medical recipient; relation to participant; purpose for medical care (not actual condition, but the general category of expense, for example, diagnosis, treatment, etc.); name of service provider; and amount of medical expenses not covered by insurance.
2. Purchase of Principal Residence – statement that the house is the participant’s principal residence; address; purchase price; types of costs and expenses covered (down-payment, closing costs and/or title fees); name of lender; date of purchase; and expected date of closing.
3. Educational Payments – name of the education recipient; relation to the participant; name of the educational institution; categories of educational payments involved (post-high school tuition, related fees, room and board); and period covered by the educational payments (beginning/end dates of up to 12 months).
4. Foreclosure/Eviction from Principal Residence – statement that the house is the participant’s principal residence; address; type of event (foreclosure or eviction); name of party that issued the foreclosure/eviction notice; date of the notice of foreclosure/ eviction; and due date of the payment to avoid foreclosure/eviction.
5. Funeral and Burial Expenses – name of the deceased; relation to the participant; date of death; and name of the service provider (cemetery, funeral home, etc.).
6. Repairs for Damage to Principal Residence – statement that the house is the participant’s principal residence; address; description of the cause of the casualty loss (fire, flooding, type of weather-related damage, etc.); the date of the casualty loss; and a description of the repairs, including the date of the repair (in process or completed).

If a summary is used, then the employer or TPA must provide the employee with the following information before allowing a withdrawal: that the withdrawal is taxable and additional taxes could apply; the withdrawal cannot exceed the amount of the financial need; the withdrawal cannot be made from earnings on elective contributions, or from QNEC or QMAC accounts, if applicable; and the employee agrees to preserve source documents and to make them available at any time, upon request, to the employer or TPA.

Although the Memorandum is not formal guidance, it does provide information on what the IRS considers sufficient substantiation and documentation for a hardship withdrawal. Note that the Memorandum does not address substantiation of non-safe-harbor hardship withdrawals, although the employer should consider applying these standards for any hardship withdrawal.

Next Steps

Sponsors of 401(k) plans that offer hardship withdrawals should review their procedures to determine if changes should be made based on this guidance. Plan sponsors should check with their TPAs to ensure that the parties agree who is responsible for processing withdrawal requests and obtaining and keeping the records necessary for substantiation.

If you have any questions about the IRS Memorandum, or require any assistance on determining whether your plan is meeting its substantiation and documentation requirements, please contact an attorney in the Sherman & Howard Employee Benefits Group.

Sherman & Howard has prepared this advisory to provide general information on recent legal developments that may be of interest. This advisory does not provide legal advice for any specific situation and does not create an attorney-client relationship between any reader and the Firm.

©2017 Sherman & Howard L.L.C.                                                                                   March 7, 2017