Do You Have Appropriate Documentation and Protocols in Place for Safe Harbor Distributions?
The IRS has indicated via memorandum the concern that not all employers properly substantiate that a hardship exists before granting a hardship distribution. With the vast majority of 401(k) retirement plans set up to allow for hardship distributions, it’s important for those employers to adhere to the strict and detailed guidelines before distributing hardship withdrawals.
Employers should continuously evaluate the protocol steps and keep sufficient records of the process. Here is an overview to understand what the regulations provide and ensure you are keeping accurate documentation for 401(k) distributions:
- Determination of Hardship: The safe harbor distribution is a distribution that is made on the account of an employee’s immediate and heavy financial need and is necessary to satisfy the financial need.
- Acquire Substantiation Documentation: Employer plans are required to obtain source documents (e.g., estimates, bills, statements and contracts) to substantiate that the distribution meets the requirements for the specific type of safe harbor distribution:
- Deductible medical expenses for the employee or the employee’s spouse, children or dependents, or primary beneficiary under the plan
- Costs directly related to the purchase of a principal residence
- Payments of tuition, related educational fees and room/board expenses for up to the next 12 months of post-secondary education for the employee or the employee’s spouse, children or dependents, or primary beneficiary under the plan
- Payments needed to prevent eviction or foreclosure of the mortgage of the employee’s principal residence
- Payments for burial or funeral expenses for the employee’s deceased parents, spouse, children or dependents, or primary beneficiary under the plan
- Qualified casualty deduction for expenses for the repair of damages to the employee’s principal residence
- Keep Summary Information and Notifications: Employer plans should obtain a summary of the information contained in the source documents, and include the following notifications made to the employee before the hardship:
- Notify employee that the hardship distribution is taxable, and additional taxes could apply.
- Advise the employee that the amount of the distribution cannot exceed the immediate and heavy financial need.
- Hardship distributions cannot be made from earnings on elective contributions or from qualified nonelective or matching contributions (if applicable).
- Agreement that the recipient will preserve source documents and make them available at any time, upon request, to the employer or administrator.
- Adhere to Guidelines: If notifications are incomplete, source documents are not included or if there are more than two hardship distributions in a year, this could flag a compliance issue. Employers should take note of the required lists defined within the IRS memorandum for each type of safe harbor distribution. The memorandum (located here) is helpful in setting forth very specific information in the source documents to satisfy regulations.
We would like to note that the memorandum is not legally binding, but it can provide guidance on what plans should do to meet the substantiation requirements and ease the process in the event of an audit.
Should you require assistance or have questions regarding specifics on hardship distribution requirements or guidelines, contact Karen Sanchez, CPA, partner in employee benefits administration, at 630-566-8519 or Karen.firstname.lastname@example.org.