Non Safe-Harbor Approvals – The Bleeding Heart

Non Safe-Harbor Hardship Approvals:

Warning: Employer Discretion Could be Ill-Advised

A Bleeding Heart

The phrase bleeding heart is used to describe one who shows excessive sympathy for another’s misfortune. Every year, we get phone calls from clients who want to help employees out of a financial bind. This emergency is not on the list of safe harbor hardships……

• “but they are paying for their own wedding and their credit cards are maxed out…”
• “but home repairs can be so costly…”
• “but they already took a plan loan and cannot afford their student loan payments”
• “but they wouldn’t have had to use their credit card to pay for the safe harbor hardship reason if they had requested a hardship distribution”

All of these examples are unquestionably unfortunate financial situations. They seem to be immediate and heavy financial needs, but not all of them are consistent with the spirit of the safe harbor hardship distributions. The employer would have to use discretion to approve a hardship distribution that would decrease the participant’s retirement readiness long-term. But does that mean that each employee’s personal story brings a new opportunity to exercise discretion to evaluate each reason?

Discretion is the Perfection of Reason

Treas. Reg. §1.401(k)-1(d)(3)(i) states that “the determination of the existence of an immediate and heavy financial need and of the amount necessary to meet the need must be made in accordance with nondiscriminatory and objective standards set forth in the plan.”

It stands to reason that the best practice is to list on the plan document which non-safe harbor hardship events will be approved consistently. Broad language that puts a plan sponsor in a position to conduct a case-by-case analysis of whether each situation justifies a hardship distribution is not ideal. A catch-all provision that results in a hardship distribution for every financially over-extended employee could get our bleeding-heart employer caught in a bind of its own… with the IRS…a different kind of hardship.

Is Credit Card Debt an Alternative Means to Pay for a Hardship?

The Regulations indicate that no alternative means should be reasonably available to pay for the hardship. But how much must the employer investigate each employee’s private finances to make this determination? For example, many people have the ability to obtain financing through a personal loan or using their credit card, but are they supposed to use all available credit before being eligible for a hardship distribution? Is the employer required to inquire? Not really.

The Regulations state that “a distribution is not treated as necessary to satisfy an immediate and heavy financial need of an employee unless each of the following requirements is satisfied—

1. The employee has obtained all other currently available distributions (including distributions of ESOP dividends under section 404(k), but not hardship distributions) under the plan and all other plans of deferred compensation, whether qualified or nonqualified, maintained by the employer;
2. The employee has provided to the plan administrator a representation in writing (including by using an electronic medium as defined in § 1.401(a)-21(e)(3)), or in such other form as may be prescribed by the Commissioner, that he or she has insufficient cash or other liquid assets reasonably available to satisfy the need; and
3. The plan administrator does not have actual knowledge that is contrary to the representation.”

Fortunately, the employee must only represent that he or she does not have enough cash or liquid assets to satisfy the need, such that the remaining credit available on their credit cards is not in question, and the employer is not required to probe. It makes sense that paying for a hardship with credit could exacerbate or perpetuate the employee’s financial hardship.

But what if the employee, desperate to meet a payment deadline, already paid for the eligible hardship distribution with a credit card and seeks reimbursement? That’s a variation of the safe harbor hardship definition that would require discretion. The Regulation has some examples of variations to the safe harbor definition of hardships to assist with the evaluation of whether there is an immediate and heavy financial need:

Immediate and Heavy Financial Need

The Regulations indicate that “whether an employee has an immediate and heavy financial need is to be determined based on all the relevant facts and circumstances. Generally, for example, the need to pay the funeral expenses of a family member would constitute an immediate and heavy financial need. A distribution made to an employee for the purchase of a boat or television would generally not constitute a distribution made on account of an immediate and heavy financial need. A financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee.”

It seems from the guidance provided above, that wedding expenses voluntarily incurred by an employee would not constitute an eligible hardship, even if the tie that binds has put the employee in a real bind. Wedding expenses are voluntarily incurred by the employee. The request should be denied.

The intent of hardship distributions is not to assist with ongoing living expenses. It’s why the employee could use a hardship distribution for a down payment on a principal residence, or to prevent eviction, but not for mortgage payments or regular rent. Similarly, credit card payments that have grown over time would not pass muster. But what if the employee paid for an eligible safe harbor hardship with a credit card and seeks reimbursement? I could see our bleeding-heart employer approving a credit card reimbursement request, so let’s take it one step further…. How would that apply to other debt incurred to pay for a safe harbor hardship, like…student loans?

Without complicating the discussion with tangent topics like employer match for student loan payments, or federal programs granting student loan forgiveness, can an employer use its discretion to permit a hardship distribution for student loan payments that are putting an employee in dire straits? The loan paid for a safe harbor hardship, tuition, so the employee’s attempt to prioritize retirement readiness and take a student loan, rather than a hardship distribution to pay tuition, seems to have backfired. In this case, we would advise the employer to consult an ERISA attorney regarding the addition of this criteria to the plan document and make it available to all employees, if appropriate.

We have seen additional hardships defined in a plan document for home repairs necessary to restore a home to an acceptable living condition. In this case, the expense is not related to natural disasters, but allows for the replacement of a heating unit, or a leaky roof or perhaps, needed handicapped access, that would render the house unlivable if not performed. Remodeling expenses, however, would not make the cut. Updating an old kitchen is not the same as replacing an inoperable stove or broken refrigerator. New windows to cut down on a pesky draft are not the same as a broken heating unit. Water damage creating mold from a faulty water heater is not the same as new flooring because it’s about time…. Even with a plan provision granting hardship distributions for home repairs that make the home livable leaves our bleeding-heart employer with a big responsibility to assess each case, based on its merits. Avoiding this uncomfortable situation is why many employers stick to the safe harbor definition of hardship:

Deemed Immediate and Heavy Financial Need

The Internal Revenue Code defines a distribution deemed to be made on account of an immediate and heavy financial need of the employee if the distribution is for—

1. Expenses for (or necessary to obtain) medical care that would be deductible under section 213(d), determined without regard to the limitations in section 213(a) (relating to the applicable percentage of adjusted gross income and the recipients of the medical care) provided that, if the recipient of the medical care is not listed in section 213(a), the recipient is a primary beneficiary under the plan;
2. Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);
3. Payment of tuition, related educational fees, and room and board expenses, for up to the next 12 months of post-secondary education for the employee, for the employee‘s spouse, child or dependent (as defined in section 152 without regard to section 152(b)(1), (b)(2) and (d)(1)(B)), or for a primary beneficiary under the plan;
4. Payments necessary to prevent the eviction of the employee from the employee‘s principal residence or foreclosure on the mortgage on that residence;
5. Payments for burial or funeral expenses for the employee‘s deceased parent, spouse, child or dependent (as defined in section 152 without regard to section 152(d)(1)(B)), or for a deceased primary beneficiary under the plan;
6. Expenses for the repair of damage to the employee‘s principal residence that would qualify for the casualty deduction under section 165 (determined without regard to section 165(h)(5) and whether the loss exceeds 10% of adjusted gross income); or
7. Expenses and losses (including loss of income) incurred by the employee on account of a disaster declared by the Federal Emergency Management Agency (FEMA) under the Robert T. Stafford Disaster Relief and Emergency Assistance Act, Public Law 100-707, provided that the employee‘s principal residence or principal place of employment at the time of the disaster was located in an area designated by FEMA for individual assistance with respect to the disaster.

A primary beneficiary under the plan is an individual who is named as a beneficiary under the plan and has an unconditional right, upon the death of the employee, to all or a portion of the employee‘s account balance under the plan.

The Distribution May Not Exceed Amount of Need

A distribution is treated as necessary to satisfy an immediate and heavy financial need of an employee only to the extent the amount of the distribution is not in excess of the amount required to satisfy the financial need (including any amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution).

Self-Certification

Historically, the Plan Administrator could not rely on the participant’s representation that he or she is eligible for a hardship distribution and its amount. The participant was required to submit proof. Plans may still require proof to approve a hardship distribution request, but now there is another alternative…self-certification.

The IRS has issued guidance for a participant self-certification process that requires two steps:

1. The Plan Administrator must provide the employee requesting the hardship distribution with information about the taxability of the distribution, the legal limitations on the amount permitted to be distributed, and the need to retain source documents to substantiate the hardship need and amount.
2. The participant must provide the Plan Administrator with a summary of the hardship event and expenses and certify that the provided information is true and accurate.

Whether the employer prefers to trust but verify, or to just trust, the process for approving hardship distributions must be implemented equally amongst all plan participants but not to all types of hardships. The employer could choose to allow self-certification for the safe harbor hardship events but require documentation for the discretionary items. When considering a deviation from the standard provisions of a plan document, each plan sponsor must collaborate with its document provider and potentially ERISA counsel. Certain pre-approved plans are required to use the hardship safe harbor standards, so our bleeding-heart employer may not be able to accommodate special requests. But what if it’s too late?….Stay tuned for our blog on corrections for ineligible hardship distributions.