The Tax Cuts and Jobs Act (Tax Act) may change the rules governing hardship withdrawals from 401(k) plans. A careful review of 401(k) plan hardship withdrawal language is required because it could impact the administration of hardship withdrawal requests.
The Bipartisan Budget Act of 2018, enacted on February 9, 2018 (Spending Act), makes certain changes to the statutory rules governing hardship withdrawals and requires that the IRS make certain additional changes to applicable regulations.
401k Plan sponsors need to understand these recent changes, and related IRS guidance, to assess whether changes in administration of hardship withdrawal requests and/or plan amendments are required.
One change made by the Tax Act is a modification of the circumstances under which taxpayers may be eligible for a deduction under Section 165 of the Internal Revenue Code (Code) with respect to a casualty loss.
For tax years beginning before January 1, 2018, a taxpayer could potentially take a casualty loss deduction pursuant to Section 165 for uncompensated damage to the taxpayer’s home resulting from any fire, storm, flood or other isolated incidents.
With the new law, in order to be deductible under Section 165 for a tax year beginning on or after January 1, 2018 and before January 1, 2026, the loss must result from a Federally-declared disaster.
The change to Section 165 of the Code may indirectly impact whether a hardship withdrawal is permitted under many 401(k) plans.
Often 401(k) plans that allow hardship withdrawals rely on “safe harbors” set forth in IRS regulations for determining whether a request satisfies the regulations’ requirements.
A safe harbor reason for determining whether the request relates to an immediate and heavy financial need (a requirement for hardship withdrawals) is to cover expenses for the repair of damage to the participant’s principal residence that would qualify for the casualty deduction under Section 165 of the Code (determined without regard to a minimum threshold that applies to the casualty loss deduction).
When a plan document specifically cross references deductibility under Section 165, permitting a withdrawal for expenses that result from an isolated incident could now be contrary to the plan’s terms. For example, the Tax Act’s changes to Section 165 may prevent a hardship withdrawal by a participant who incurs expenses to repair damage to his or her principal residence resulting from an isolated incident, such as a fire or thunderstorm.
Whether Congress intended to narrow the circumstances in which a hardship withdrawal may be taken when enacting the change to Section 165 is unclear. The IRS may publish guidance obviating the need to impose the Federally-declared disaster requirement in the hardship context.
Nevertheless, a 401(k) plan sponsor needs to be sure that its tax-qualified plan is administered in accordance with the plan’s terms. Therefore, the Section 165 changes should be taken into account if necessary in light of plan language, or plan administrators should forego use of the IRS safe harbor and plan documents should be amended if necessary to ensure the plan is administered in accordance with the plan language.
Plan sponsors may also wish to consider future changes to hardship withdrawal administration to take advantage of additional flexibility enacted by the Spending Act, which apply to plan years beginning after December 31, 2018.
The Spending Act directly expands availability of hardship withdrawals to qualified non-elective contributions, qualified matching contributions, and earnings, which amounts are not eligible for distribution due to hardship under current rules. Further, the Spending Act modifies current rules that require a participant, in some circumstances, to have exhausted any available plan loans before taking a hardship withdrawal.
Under current IRS regulations, a hardship withdrawal will be deemed necessary to satisfy an immediate and heavy financial need (also a requirement for hardship withdrawals) if certain requirements are met, including that the participant is restricted from contributing to the plan and all other plans maintained by the employer for at least six months after taking the withdrawal.
The Spending Act directs the IRS to modify the regulations so that the six-month suspension is not required to rely on the safe harbor.