Employees no longer routinely have to provide their employers with documentation proving they need a hardship withdrawal from their 401(k) accounts, according to the Internal Revenue Service (IRS). Employees do, however, need to keep source documents, such as bills that resulted in the need for hardship withdrawals, in case employers are audited by the IRS, the agency said.
Due to uncertainties in how the IRS would handle audits, conservative employers may still choose to require employees to provide source documentation even before audits, said Marcia Wagner, an attorney with The Wagner Law Group in Boston.
In recent years, many institutions administering the records for 401(k) accounts have allowed employees to report on the account administrator's website that they have a hardship and need to make a withdrawal, without requiring them to submit documentation or bills to show why they need the money, noted Brenna Clark, an attorney with Eversheds Sutherland in Atlanta. But if those 401(k) plans were audited, IRS agents would ask the employers for proof that the withdrawals were due to hardships. Agents did not think the self-certification electronic policy was enough, Clark said, and expected these third-party record-keepers or employers to have copies of the bills that gave rise to the hardship withdrawals.
In 2015, the IRS issued a newsletter saying that employers should ask for and keep physical proof of the need for hardship withdrawals, such as medical bills. An employee providing a summary of the cause for withdrawal on the third-party record-keeper's website was not enough, she noted.
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But in a Feb. 23 memorandum to IRS agents, the agency changed its position on the documents needed to substantiate a hardship withdrawal, Wagner said. "Previously, the IRS would be looking for source documents to substantiate a hardship withdrawal," she said. "But the new guidance permits the use of a summary of the information contained in the source documents."
Under this guidance, to rely on a summary of information, the third-party record-keeper or employer needs to send the employee a notice that requires the employee to agree to preserve the underlying source documents (e.g., bills) and make them available at any time upon the request of the employer or third-party record-keeper.
Hardship Information
Source documents for these specific hardship withdrawals should note:
Medical care
- Who incurred the medical expenses?
- What is the relationship to the participant (self, spouse, dependent or primary beneficiary under the plan)?
- What was the purpose of the medical care (e.g., diagnosis, treatment, prevention or long-term care)?
- What is the name and address of the service provider?
- What amount of medical expenses was not covered by insurance?
Purchase of principal residence
- Will this be the participant's principal residence?
- What is the address of the residence?
- What is the purchase price of the principal residence?
- What are the types of covered costs and expenses (e.g., down payment, closing costs and title fees)?
- What is the name and address of the lender?
- What is the date of the purchase or sale agreement?
- What is the expected date of closing?
Educational payments
- Who are the educational payments for?
- What is the relationship to the participant?
- What is the name and address of the educational institution?
- What are the categories of educational payments involved (e.g., post-high school tuition, related fees, room and board)?
- What is the period covered by the educational payments?
Foreclosure/eviction from principal residence
- Is this the participant's principal residence?
- What is the address of the residence?
- What is the type of event—foreclosure or eviction?
- What is the name and address of the party that issued the foreclosure or eviction notice?
- What is the date of the notice of foreclosure or eviction?
- What is the due date of the payment to avoid foreclosure or eviction?
Funeral and burial expenses
- What is the name of the deceased?
- What is the relationship of the deceased to the plan participant?
- What is the date of death?
- What is the name and address of the service provider (e.g., cemetery or funeral home)?
Repairs for damage to principal residence
- Is this the participant's principal residence?
- What is the address of the residence that sustained damage?
- What is the cause of the casualty loss (e.g., fire, flooding or type of weather-related damage), including the date of the loss?
- What are the repairs and their date, and are they are in process or completed?
"If any of those items was omitted from the summary, the summary would be incomplete," Wagner observed.
Be careful of inconsistencies such as a medical service invoice for services after a funeral date or an expense for a casualty loss prior to the date of the casualty, she noted. "In these circ*mstances, the agent will ask the employer or the TPA [third-party administrator] for the source documentation. This is where a potential risk exists for the employer and why the IRS has in the past been reluctant to accept self-certification."
The information may have been lost or misplaced or the employee no longer works for the employer by the time the audit is conducted years later. "It is unclear from the memorandum what action the agent would take in this circ*mstance, and it might depend upon how serious the incomplete or inconsistent summary was," she noted.
Employees Should Keep Documentation
Employers and third-party record-keepers should at the very least make it clear to the employee that he or she should keep physical proof of the need for the hardship withdrawal and make the proof available at any time on request by the employer, Clark said. If employers are allowing employees to take more than two hardship withdrawals a year, they might require physical proof up front rather than waiting for an IRS audit, she added. Or an employer could limit employees to two hardship withdrawals a year.
Some employers prefer for employees to have unlimited access to their accounts, she noted. However, other plans prefer to help employees to keep their money in the plan and grow it for retirement. The difference in treatment comes down to employers' philosophy toward hardship withdrawals, Clark said.
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