Employee Benefits-Recent Tax Legislation Changes Some Of The Rules For Hardship Withdrawals, Starting In 2019

Recent tax legislation has changed some of the rules of the Internal Revenue Code (the “Code”) and the underlying regulations that apply to hardship withdrawals from 401(k) and 403(b) plans.  These changes are effective as of the plan year starting in 2019 (January 1, 2019 for calendar year plans), and are as follows, according to the preamble to the new proposed regulations (discussed below):

Changes Affecting 401(k) Plans.

Section 41113 of the Bipartisan Budget Act of 2018 (the “BBA”) directs the Secretary of the Treasury to modify Treas. Reg. §  1.401(k)-1(d)(3)(iv)(E) to: (1) delete the 6-month prohibition on pre-tax and after-tax employee contributions following a hardship distribution and (2) make any other modifications necessary to carry out the purposes of section 401(k)(2)(B)(i)(IV) (which allows distribution of pre-tax employee contributions for hardship).  The prohibition in (1) had been a part of the “safe harbor” hardship distribution rules.

Section 41114 of the BBA modifies the hardship distribution rules under section 401(k)(2)(B) by adding section 401(k)(14)(A) to the Code, which states that the amounts which may be distributed in the event of a hardship include: (a) pre-tax employee contributions, (b) qualified nonelective contributions (or “QNECs”), (c) qualified matching contributions (or “QMACs”), and (d) earnings on these contributions (including post 1988 earnings on pre-tax employee contributions).  Section 41114 of the BBA also adds section 401(k)(14)(B) to the Code, which provides that a distribution is not treated as failing to be made upon the hardship of an employee solely because the employee does not take any available loan under the plan.  The loan requirement had also been a part of the “safe harbor” hardship distribution rules.

Changes Affecting 403(b) Plans.

Treasury Reg. § 1.403(b)-6(d)(2) provides that a hardship distribution of section 403(b) pre-tax employee contributions is subject to the rules and restrictions set forth in Treas. Reg. § 1.401(k)-1(d)(3); thus, the proposed new rules relating to a hardship distribution of pre-tax employee contributions from a section 401(k) plan generally apply to section 403(b) plans.  However, Code section 403(b)(11) was not amended by section 41114 of the BBA.  Therefore, income attributable to section 403(b) pre-tax employee contributions continues to be ineligible for distribution on account of hardship.

Amounts attributable to QNECs and QMACs may be distributed from a section 403(b) plan on account of hardship only to the extent that, under Treas. Reg. § 1.403(b)-6(b) and (c), hardship is a permitted distribution event for amounts that are not attributable to section 403(b) pre-tax employee deferrals.  Thus, QNECs and QMACs in a section 403(b) plan that are not in a custodial account may be distributed on account of hardship, but QNECs and QMACs in a section 403(b) plan that are in a custodial account continue to be ineligible for distribution on account of hardship.

Proposed Regulations and The Effective Date.

On November 14, 2018, the IRS and the Treasury Department issued proposed regulations implementing the foregoing changes.

The preamble to the proposed regulations state that the changes to the hardship distribution rules made by the BBA are effective for plan years beginning after 2018.  The proposed regulations, if adopted, would also apply for those plan years.  However, the prohibition on suspending an employee’s pre-tax and post-tax employee contributions, as a condition of obtaining a hardship distribution, may be applied as of the first day of the first plan year starting after 2018, even if the distribution was made in the prior year.  Thus, for example, a calendar year plan that provides for hardship distributions under the pre-2019 safe harbor standards may be amended to provide that an employee who receives a hardship distribution in the second half of the 2018 plan year will be prohibited from making contributions only until January 1, 2019 (or may continue to provide that contributions will be suspended for the originally scheduled 6 months).

While a 401(k) or 403(b) plan can implement the statutory changes as of their effective date, the proposed regulations indicate that, if they are adopted, a plan (at least a 401(k) plan) will have to be amended to use the changes to the hardship distribution rules, by the time described in the preamble.  We will further explore the new regulations once they have been finalized.