Hardship Distribution and Loan Documentation - July/August 2015

The April 2, 2015, edition of the IRS newsletter for plan sponsors (Employer Plan News) contained an important reminder: Plan sponsors that permit hardship distributions or participant loans should review their current practices to ensure they are operating in compliance with IRS requirements.

Hardship distributions

The IRS makes it clear that a plan sponsor is obligated to retain the following paperwork:

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

Failure to have these records available is a plan qualification failure. It is not sufficient for the participant to retain his or her own hardship distribution records; the plan sponsor must retain documentation that demonstrates the nature of a hardship. The IRS noted that while participants are permitted to “self-certify” that they have a financial hardship, self-certification — filed electronically or on paper — is not enough to prove the nature of a hardship request.

Example: John requests a hardship distribution to pay a hospital for unreimbursed medical expenses. He certifies that he has no other means of satisfying the hardship besides taking a distribution from his 401(k) account. However, John does not submit any hospital bills to the plan sponsor and simply signs a form indicating he is using the funds to pay unreimbursed medical expenses. If the plan sponsor approves John’s request without obtaining and retaining supporting documentation that reflects the amount John owes to the hospital, the plan sponsor is not in compliance with the IRS’s documentation and retention requirements.

Participant loans

The IRS requires plan sponsors to retain similar documentation with respect to participant loans, including the following:

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

During audits, the IRS has found that some plan sponsors permit participants to self-certify their own loan eligibility. When a participant requests a loan in excess of five years for the purchase or construction of a primary residence, the plan sponsor is required to obtain documentation of the purchase prior to approving the loan.

In reviewing the responses to the 401(k) questionnaire sent to employers in 2010, the IRS discovered that instead of an administrator overseeing the actual operation of the plan, it has, in many cases, been relegated to a computerized investment platform with no procedure in place to actually ensure the hardship distribution is for an allowable reason or for a proper amount. The IRS also discovered there is often minimal oversight regarding plan loan repayments being made according to the amortization schedule.

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