IRS guidance sought following hardship withdrawal, loan documentation warning

IRS guidance sought following hardship withdrawal, loan documentation warning

401k-withdrawal2-crop-600x338Defined contribution plan sponsors remain in regulatory limbo regarding their obligations to maintain detailed documentation surrounding employee 401(k) hardship withdrawals.

In April, in its periodic Employee Plan Newsletter, the IRS stated that, regardless of what records third-party administators maintain, sponsors should “retain these records in paper or electronic format:”

  • Documentation of the hardship request, review and approval;
  • Financial information and documentation that substantiates the employee’s immediate and heavy financial need;
  • Documentation to support that the hardship distribution was properly made in accordance with the applicable plan provisions and the Internal Revenue Code; and
  • Proof of the actual distribution made and related Forms 1099-R.

Many employers – including the federal government itself – rely on employees’ own certification to satisfy hardship withdrawal eligibility criteria. But the IRS asserted that “electronic self-certification is not sufficient documentation of the nature of a participant’s hardship. … While self-certification is permitted to show that a distribution was the sole way to alleviate a hardship, self-certification is not allowed to show the nature of a hardship.”

Can’t rely on participants?

The IRS explained that it’s insufficient to expect plan participants to keep their own records of hardship distributions because “participants may leave employment or fail to keep copies of hardship documentation, making their records inaccessible in an IRS audit.”

The IRS also warned that “failure to have these records available for examination is a qualification failure that should be corrected using the Employee Plans Compliance Resolution System.”

With respect to plan loans, the IRS instructed plan sponsors to maintain the following records regarding loans granted:

  • Evidence of the loan application, review and approval process;
  • An executed plan-loan note;
  • If applicable, documentation verifying that the loan proceeds were used to purchase or construct a primary residence;
  • Evidence of loan repayments; and
  • Evidence of collection activities associated with loans in default and the related Forms 1099-R, if applicable.

Industry response

The IRS outline of this apparently new policy prompted a detailed letter from the American Benefits Council and the SPARK Institute Inc. The letter argued that the new IRS pronouncement isn’t supported by ERISA and “appears[s] inconsistent with other information provided by the Service, including statements on the Service’s website and in public forums.”

Fidelity Investments also issued a detailed memo to its plan sponsor clients supporting its own new hardship distribution procedure “that does not require that a participant submit supporting documentation.”

The form that employees must fill out when requesting a hardship withdrawal “indicates that the employee must retain documentation of the facts and circumstances surrounding his or her situation that the plan administrator reserves the right to request copies of the documentation.”

While asserting its confidence that its processes satisfy statutory requirements, Fidelity encouraged sponsors to “review the new procedures with your legal counsel” to ensure their consistency “with the qualification requirements and your plan documents.”

Push for internal controls

In a recent blog post, Sheldon Smith and Sarah Sise, attorneys with Bryan Cave, commented that the IRS has recently “been pushing for plans to utilize good internal controls.”

“Apparently,” they concluded, “reliance on your TPA, no matter how competent and no matter how good its systems, is not a satisfactory internal control and is inadequate when it comes to leakage.”

According to Michael L. Hadley, SPARK’s general counsel, the manner in which the IRS disseminated its policy statement, a newsletter, means that it’s “only informational or informal commentary.” SPARK and ABC expressed concern that “some may incorrectly interpret it as guidance.”

“Guidance” carries more regulatory authority than a policy statement released in a newsletter.

The IRS “has not formally responded” to the letter, according to Hadley, “but we’re optimistic” that the agency will resolve concerns raised by the groups “in the foreseeable future.”