The recent tax reforms may narrow the circumstances in which hardship distributions are available. Prior law dealing with casualty loss deductions allowed taxpayers to claim a deduction for property losses caused by heavy winds, storm water, extreme snow or ice, fires and similar events. Under the 401(k) and 403(b) regulations, hardship distributions may only be made on account of a participant’s immediate and heavy financial need. The regulations allow plans to satisfy this requirement through either a “facts and circumstances” analysis or six “safe harbor” categories.
One safe harbor category, for damage to a 401(k) or 403(b) plan participant’s home, cross-references the casualty loss deduction rules, so hardship distributions were previously available in the same circumstances noted above. As of January 2018, however, the Tax Cuts and Jobs Act limits casualty loss deductions to those occurring in a federally declared disaster area. As a result, damage to a plan participant’s principal residence that was not caused by a federally declared disaster is no longer eligible for a hardship distribution (at least not under the safe harbor).
Sponsors of 401(k) and 403(b) plans that currently permit hardship distributions under the safe harbor standards will need to consider their next steps. One possibility would be to follow the letter of the law and limit hardship distributions to home repair costs arising from a federally declared disaster. Or, sponsors of individually designed plans might consider switching to the more flexible facts-and-circumstances approach to granting hardship distributions (although the switch could complicate plan administration). Finally, some sponsors may choose to adopt a wait-and-see approach as the IRS might modify its regulations to continue permitting hardship distributions in accordance with the prior law. The fact that the budget deal (discussed below) directs the IRS to amend the hardship distribution regulations increases the chances that the agency will address the casualty loss issue as well.
Additionally, the Bipartisan Budget Act of 2018 made more direct changes to hardship distributions, which become effective starting in 2019. In general, these changes relaxed some of the requirements for hardship distributions from 401(k) and 403(b) plans. More specifically, the new law:
- Directs the IRS to make changes to the hardship distribution regulations to (1) eliminate the existing safe harbor rule that prohibits individuals from making elective deferrals for six months after a hardship distribution, and (2) make any other modifications necessary to carry out the purposes of the hardship distribution rules
- Provides that qualified nonelective contributions (QNECs), qualified matching contributions (QMACs) and earnings on such contributions may be made available for hardship distributions (prior to the budget act, only participant elective deferrals and pre-1989 earnings on such deferrals were eligible for distribution upon hardship)
- Eliminates the requirement that individuals take any available plan loans before taking a hardship distribution
These budget act changes are optional for plan sponsors.
Plan sponsors will need to review the changes to the hardship rules enacted by tax reform and the budget act, amend their plan in a timely fashion so the language conforms to its administration, and update related hardship distribution forms and plan communications.