In February, the IRS released a memo to its employee plan examiners with guidance on the documents needed to substantiate the “immediate and heavy financial need” requirement. It allows a summary of information from source documents instead of the original source documentation, although either is acceptable.
Guidelines for Hardship Distributions
A 401(k) plan may (but does not have to) allow distributions if the participant occurs a severe financial hardship that cannot be met by other resources. The IRS offers six “safe-harbor” reasons for hardship distributions:
- Medical expenses of the participant, spouse or dependents.
- Costs related to the purchase of the participant’s principal residence.
- Payment of tuition, room and board and related educational expenses for secondary education for the participant, spouse or dependents.
- Payments necessary to prevent the eviction of the employee from his principal residence or of foreclosure on that residence.
- Burial and funeral expenses for the participant, spouse or dependents.
- Expenses for the repair of the participant’s principal residence that would qualify as a casualty deduction under section 165.
There has been significant confusion about the amount of information the participant can “self-certify” to the plan sponsor. The plan sponsor may accept a certification that the expenses cannot be met by another source to avoid getting into specifics about the participant’s personal finances. Some plan sponsors and recordkeepers have allowed self-certification for the reason and amount of the hardship distributions.
However, the recent IRS memo indicates this is not sufficient information for the plan sponsor to meet the hardship requirements. The plan sponsor must retain either original source documents from the participant indicating the amount of the hardship or a summary of such expenses.
The summary of information approach poses a few problems. Even if the participant certifies the underlying documentation exists and will be turned over in the event of an IRS examination, if the participant doesn’t produce the documents during an actual examination (e.g., maybe the participant has since terminated employment), the IRS can threaten plan disqualification. This may also result in plan corrections via AuditCAP and sanctions.
The bottom line is that documentation must be maintained for every hardship distribution. While the recordkeeper may do the majority of the heavy lifting when it comes to hardship distributions, it is incumbent on the plan sponsor to make sure either the original source documentation or the specific summary of source information is retained.
Meet the Author
Retirement Plan Consultant
Jeff Clark, CFP®, CPFA
Aldrich Wealth LP
Jeff has assisted families with financial planning and retirement income strategies since 2010. As a retirement plan consultant, he helps plan sponsors and trustees meet their fiduciary obligations. He provides investment advice, compliance reviews, and employee education. Jeff also has 14 years of active and reserve service as an officer in the U.S. Navy. Jeff completed…
- Financial planning
- Retirement planning
- Certified Financial Planner™
- Certified Plan Fiduciary Advisor (CPFA)