A memorandum issued to Internal Revenue Service (IRS) Employee Plans (EP) Examinations employees sets forth standards for examining whether a section 401(k) plan hardship distribution is “deemed to be on account of an immediate and heavy financial need” under safe-harbor standards set out in the Income Tax Regulations.

The memorandum notes that, “A distribution is deemed to be on account of an immediate and heavy financial need” under § 1.401(k)-1(d)(3)(iii)(B) of the Income Tax Regulations if it is for one or more of the following:

• Expenses for medical care deductible under section 213(d) for the employee or the employee’s spouse, children or dependents (as defined in section 152) 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 or dependents (as defined in section 152) or primary beneficiary under the plan;
• Payments 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 or dependents (as defined in section 152) 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.

NEXT: What the examiner will do

The memorandum states that the examiner should determine whether the employer or third-party administrator, prior to making a distribution, obtains source documents (such as estimates, contracts, bills and statements from third parties), or a summary (in paper, electronic format, or telephone records) of the information contained in source documents. If a summary is used, the agent should determine whether the employer or third-party administrator provided the employee with notification required prior to making a hardship distribution. (Notifications are included as an attachment to the memorandum.) 

The examiner should then review the source documents to determine if they substantiate the hardship distribution, or examine the summary of information on source documents to determine whether it contains the relevant items listed on the notification to employees.

If the notification provided to employees in or the information reviewed are incomplete or inconsistent on its face, the examiner should ask for source documents from the employer or third-party administrator to substantiate that a hardship distribution is deemed to be on account of an immediate and heavy financial need.

The IRS agents will also look to see if employees have received more than two hardship distributions in a plan year. In the absence of an adequate explanation for the multiple distributions and with managerial approval, they may ask for source documents from the employer or third-party administrator to substantiate the distributions. The IRS says examples of an adequate explanation include follow-up medical or funeral expenses or tuition on a quarterly school calendar.

The agency also tells examiners “If a third-party administrator obtains a summary of information contained in source documents, determine whether the third-party administrator provides a report or other access to data to the employer, at least annually, describing the hardship distributions made during the plan year.”

If all applicable requirements are satisfied, the plan should be treated as satisfying the substantiation requirement for making hardship distributions deemed to be on account of an immediate and heavy financial need.