When participants request hardship distributions from a 401(k) plan, employers must collect and store documents showing that the participant had an immediate and heavy financial need to permit such a distribution. In today’s digital age, you might wonder whether you could instead allow participants to certify their needs electronically.
The short answer is a tentative “yes” — if you already use self-certification to establish the necessity of the requested distribution and carefully follow a procedure authorized by the IRS a couple of years ago.
A review of the rules
A 401(k) plan can make a hardship distribution only if the participant experiences an “immediate and heavy financial need,” and the distribution is “necessary to satisfy the financial need.” The regulations expressly allow participants to self-certify that a requested distribution is the sole way to alleviate a financial need. Alternately, a plan could use information known to the sponsor and suspend deferrals, which relieves the plan of having to collect documentation about the participant’s lack of other resources.
But those strategies address only whether the distribution is “necessary.” They don’t eliminate the need to document the nature of the participant’s hardship. Previously, the informal IRS position was that a plan had to obtain certain records in paper or electronic format before making hardship distributions, including documentation substantiating the participant’s financial need. Self-certification was considered insufficient.
In 2017, however, the IRS announced in audit guidelines, which have subsequently been incorporated into the Internal Revenue Manual and IRS online resources, that plans could use a “summary substantiation method” for the safe-harbor financial needs that are deemed sufficient to permit a hardship distribution. Under this method, participants can provide a summary of the relevant information specified for the hardship on paper, in electronic form or in telephone records, instead of delivering source documents.
To satisfy the substantiation requirements:
- Prescribed notifications must be given to participants regarding the source, amount and taxation of hardship distributions,
- Participants must agree to preserve the source documents and make them available upon request,
- A participant must provide a complete and consistent summary of required information for the claimed hardship, and
- If the summary is provided to a third-party administrator (TPA), the TPA must give the employer, at least annually, a report describing the hardship distributions made during the year or provide access to the data.
If you use a TPA, it should be able to assist you in converting to the summary substantiation method. But, remember, even when a TPA manages the process, the plan sponsor is responsible for ensuring that sufficient paper or electronic records are retained to support the plan’s actions in the event of an audit or dispute.
Using an e-certification process for hardship distributions under the summary substantiation method is certainly feasible. But it’s important to follow the rules carefully. Failure to adequately substantiate a participant’s financial hardship is an operational qualification failure requiring correction under the Employee Plans Compliance Resolution System. Contact us for more information.