This can be done in one of two ways: (1) The employer or third-party administrator retains the source documents for substantiation, or (2) the participant provides a signed summary certifying the information contained in the source documents. If a summary of information on source documents is utilized, there are certain notifications that the employer or third-party administrator must provide to the employee prior to making the hardship distribution:
- The hardship distribution is taxable and additional taxes could apply.
- 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 QNEC or QMAC accounts, if applicable.
- The recipient agrees to preserve source documents and to make them available at any time, upon request, to the employer or administrator.
Hardship withdrawals are allowed only if the distribution is made due to an immediate and heavy financial need of the employee and is necessary to satisfy the financial need. One or more of the following is required:
- Expenses for medical deductibles for the employee or the employee’s spouse, children, dependents or primary beneficiary under the plan;
- Costs directly related to the purchase of a principal residence;
- Payment of tuition, related educational fees, room and board expenses for up to the next 12 months of post-secondary education for the employee or the employee’s spouse, children, dependents or primary beneficiary under the plan;
- Payment necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence;
- Payments for burial or funeral expenses for the employee’s deceased parents, spouse, children, dependents or primary beneficiary under the plan; or
- Expenses for the repair of damages to the employee’s principal residence that would qualify for the casualty deduction under Section 165.
IRS field agents are instructed to review distributions to determine whether they are made because of a deemed immediate and heavy financial need. If the source documents are maintained by the employer or third-party administrator, the field agent will review the documents to determine if they substantiate the hardship distribution. If a summary of the information on source documents is used, the field agent will review the summary and determine whether the employer or third-party administrator provided the employee the proper notifications prior to making the hardship distribution. Furthermore, if a third-party administrator obtains a summary of information, the field agent is to determine whether the third-party administrator provided a report or access to data to the employer, at least annually, describing the hardship distributions made during the plan year.
In summary, employers and third-party administrators must understand and apply the new substantiation guidelines prior to approving hardship distributions. This will minimize any questions or issues should they be subject to an IRS audit in the future.
Sandy P. Purdy, CPA, is a senior manager in Lindquist LLP’s San Ramon office. She has spent nearly 20 years in public accounting, working with employee benefit plans of various sizes, complexities and structures. She performs both full and limited-scope audits of more than 25 defined contribution and defined benefit plans with more than $550 million in total assets.