Assessing Likely Impacts of IRS Hardship Withdrawal Rule Changes

Art by Claudi Kessels

Back in 2018, the Republican-controlled Congress enacted statutory changes affecting 401(k) plans as part of the Bipartisan Budget Act of 2018, including changes to the rules for accessing hardship withdrawals.

The broad consensus at the time was that Congress was making it significantly easier for participants to access 401(k) dollars in the case of hardship, for example by allowing participants to simply self-certify that they are experiencing a financial hardship. Previously, the employer was required to obtain documentation from the employee, detailing and proving the hardship. Furthermore, under the old system, participants would have to suspend additional deferrals into the plan for six months after taking a hardship withdrawal; the new system bans this requirement.

In November 2018, the Internal Revenue Service published detailed guidance that effectively built out the practical framework it will be using to apply the new rules established by Congress. Experts have now had some time to absorb the IRS guidance, but they are still split on exactly what the broad retirement industry impact could be. 

Reviewing Changes to IRS Hardship Rules

At a high level, the IRS’s rules governing hardship withdrawals are organized around two broad considerations, says Amy Ouellette, director of retirement services at Betterment for Business in New York. The first area sets out why a retirement plan participant could apply for a hardship withdrawal, and the second discusses the standard for determining whether a given hardship request in fact involves an immediate and heavy financial need.

With the new changes, a seventh broad reason (disaster-related casualty losses) has been added to the IRS list of reasons why a retirement plan participant could apply for a hardship request, Ouellette says. The list now includes the following items:

• Medical expenses that are not reimbursed
• Purchasing a primary residence
• Avoiding eviction or foreclosure
• Repairing damages to one’s primary residence
• School tuition fees and room and board for a family member or beneficiary
• Funeral expenses
• Disaster-related casualty losses

Another important change to consider is that, previously, participants could only withdraw contributions to their 401(k)—not earnings or matches, Ouellette says. Now, however, participants can be permitted to withdraw from those additional sources, she says.

Furthermore, there isn’t a stated IRS limit on how much a person can withdraw for a hardship, Ouellette says. For instance, if they are facing foreclosure or eviction, they could withdraw $200,000 or more. However, she adds, a plan sponsor’s own policies around loans may not permit such a sizable withdrawal.

Mike Windle, a retirement planning specialist at C. Curtis Financial in Plymouth, Michigan, has never witnessed a hardship withdrawal of that magnitude. “The most I ever saw a sponsor permit was a maximum of 25% of a person’s balance,” Windle says. “Typically, they are capped at 10% to 15% of one’s balance.”

Previously, a participant had to exhaust the loans available to them before taking out a hardship withdrawal. Congress and IRS have changed that to permit sponsors to sidestep the loans to allow participants to go straight to the hardship withdrawal. Several experts say that, because participants are required to repay the loans back to their accounts, loans are much more preferable than hardship withdrawals from the retirement security perspective. Hardship withdrawals cannot be repaid in the same way.

To be clear, as noted in a summary published by attorneys with Kramer Levin, the new system eliminates the old requirement that elective deferrals be suspended for a period of six months following a participant’s receipt of a hardship distribution. “Under the proposed amendment to the regulations, while sponsors may eliminate the six month suspension for plan years beginning on or after January 1, 2019, plan sponsors must eliminate the suspension required for plan years beginning on or after January 1, 2020,” the attorneys explain. Further, while the new system eliminates the requirement that a participant must take any available loans under the plan prior to taking a hardship distribution starting in 2020, it does not establish that plan sponsors cannot keep this requirement.

“Unlike a loan, you don’t pay the hardship withdrawal back,” says Tom Foster, national spokesperson for MassMutual’s workplace solutions unit in Enfield, Connecticut. “That money is just gone and there is no way to make that up unless you increase your deferrals to your 401(k), but most employees taking out a hardship withdrawal are unable to do that.” Additionally, Foster notes, the funds are subject to taxes, and if the participant is under the age of 59 1/2, they have to pay a 10% penalty.

Whether an individual is taking out a loan or a hardship withdrawal, those leakages set their final retirement nest egg back by 14% on average, he notes.

IRS Addresses Participant’s Immediate Needs

Dominic DeMatties, a partner with Alston & Bird in Washington, D.C., says he believes that Congress has made it possible for plan sponsors to permit participants to sidestep loans before taking out a hardship withdrawal due to the immediate needs that these participants face.

“Congress has recognized that for people under financial duress, it may not be practical for them to wait for the whole process of taking out a loan and then seek a hardship withdrawal,” DeMatties says. “So, instead of requiring someone go through two hurdles to get to a predetermined end game, they are making it possible for a person to just go through one hurdle, which takes less time.”

Snezana Zlatar, senior vice president and head of full service product and business management at Prudential Retirement in Woodbridge, New Jersey, agrees: “Congress has focused on individuals undergoing true hardship. In that context, we believe that the elimination of the loan requirement actually does make sense because if an individual is in a tough financial situation, loan repayments could very well be a financial burden to them. Additionally, loans may not be enough to meet their financial hardship.”

Mike Zovistoski, managing director at UHY Advisors in Albany, New York, has not witnessed many participants taking out hardship withdrawals. He believes one of the main reasons is that employees do not always want their employer to know about what they may feel is an embarrassing financial situation.

“Concerns about having your employer know your financial status has discouraged a lot of employees from taking hardship withdrawals,” he says. Furthermore, most of his plan sponsor clients “have the paternal instinct,” Zovistoski says. “They want to protect employees from themselves,” so he does not expect many of his clients to make plan design changes to permit their employees to take out a large hardship withdrawal without first going down the loan route.

So, Will Hardships Increase?

Stepping back and assessing this moving picture, Windle says that with so many people wanting to access their 401(k) funds before retirement, he is afraid that the new IRS provisions could lead to more leakage. “There aren’t a lot of people hip to [this new system] yet,” Windle says. “But once people start to realize this is available, they are going to start to use it. 401(k)s were created to incentivize saving for retirement. To use the funds ahead of time puts us back at square one.”

DeMatties agrees: “Without a doubt, the new rule makes it easier for people to access money in the event they have a hardship. Where the jury is still out is to what extent participants will utilize these procedures and access the money even when they do not truly qualify for one of the seven reasons the IRS has spelled out.”

Zlatar says one way retirement plan advisers and sponsors can discourage participants from taking out either an unneeded loan or a hardship withdrawal is by helping them set up an after-tax emergency savings feature. Prudential and other providers have already built such features into their recordkeeping platforms. “Our position is that a short-term emergency savings option within the 401(k) plan is the best alternative to a loan or hardship withdrawal, which is why we make this available,” Zlatar says.

Educating participants about the need to establish a budget and an emergency fund should also be part of that equation, Foster says. Sponsors should also offer alternatives to 401(k) leakage, such as health savings accounts (HSAs), long-term or critical illness insurance and information on low-cost loans, he says.

A participant might also rethink taking out a loan or hardship withdrawal if the sponsor requires them to sign a document outlining the downsides, Foster adds.

Other Considerations

One positive component of the new rules is that people with hardship withdrawals will no longer be precluded from contributing to their 401(k) for six months, notes Chad Parks, chief executive officer of Ubiquity Retirement + Savings in San Francisco. Because of inertia, that requirement has often led to participants never resuming deferrals to their 401(k), Parks says.

“That could help substantially with retirement readiness,” he says, “because you are no longer asking people to stop contributing to their 401(k). With participants continuing to contribute to their 401(k), I would hope that these people will still come out ahead.”

One other important aspect related to the new rules is that a sponsor no longer is required to keep evidence of the hardship expense and also may rely on the participant’s representation that he or she has no other financial means to alleviate the hardship, DeMatties says. “Instead, the sponsor can keep a summary of what is in the source documents that substantiate the hardship expense,” he says. However, the IRS might conduct a plan audit and ask for those source documents if certain requirements are not met, he warns. For that reason, Zovistoski believes it is a best practice for sponsors to still require copies of the source document.