Hardship Question

Good Morning - 

40 year old participant requested a hardship withdrawal from his 401(k) account to purchase a principal residence.  The purchase of a principal residence is listed as one of the safe harbors for hardships in the plan document and there are no maximums or restrictions listed.  Participant submitted the purchase agreement and is requesting the entire purchase price of $500,000 as a hardship withdrawal.  Participant certified they do not have other assets to satisfy the financial need and the employer does not have any information to the contrary.  Any issue outside of the financial hit to the participant as a taxable distribution subject to a 10% early withdrawal penalty? It certainly goes against the spirit of a hardship, but the purchase of a principal residence (without limitation) is deemed an immediate and heavy financial need.  

I appreciate your thoughts. 

One could argue the "immediate" need because it is unlikely that they "need" the full purchase price. More than likely, they could be approved for a loan on 80%+ of the property.

If I were the Sponsor I would request proof that the participant attempted to obtain a mortgage and were not approved. 

22 minutes ago, 401king said:

One could argue the "immediate" need because it is unlikely that they "need" the full purchase price. More than likely, they could be approved for a loan on 80%+ of the property.

If I were the Sponsor I would request proof that the participant attempted to obtain a mortgage and were not approved. 

Under your reasoning:

Someone may not "need" the entire amount for the semester tuition bill; they can just take a loan.

Someone may not "need" that facelift or tummy tuck, so it's not an acceptable hardship request.

There is no requirement in the code or regs that the participant obtain a loan (from the plan or otherwise) before receiving a hardship withdrawal. The plan may impose such a restriction, however.

The safe harbor defined in the regs is that "Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments)" are deemed immediate and heavy.

It is almost certainly a terrible financial decision, given the 10% early withdrawal penalty, and the current interest rate environment, however if it is permitted by the plan I do not think you can stop the participant if that is what they really want to do.

While I don’t conclude any particular answer, here’s a bit of framework for thinking about the questions.

The point of a deemed need is that an administrator follows it without evaluating whether the claimant truly needs what the claim asks for, to the extent that it is within the deemed need.

26 C.F.R. § 1.401(k)-1(d)(3)(ii)(B)(2) ends with the phrase “(excluding mortgage payments)”.  And a plan’s governing document might include some text meant to follow this.

An administrator might interpret the plan’s provision to allow no more than the amount the claimant would pay to buy the residence had he financed with a mortgage the portion of the purchase price that typical principal-residence purchasers usually so finance.  (This is only one of several possible interpretations.)

A plan might allow a gross-up for “any amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution”.

An administrator must explain its denial (or partial denial) of a claim.  Consider including a written explanation of the administrator’s interpretation.

The textual analysis might include analyses of the whole texts—that is, of the whole rule, and of the whole statute the rule interprets and implements.

The administrator might follow carefully its claims procedure.  If the claimant complains, afford the claimant an opportunity to present any further facts that might support his claim.  If a complaint is about the interpretation, invite the claimant to present his legal argument.

If the plan grants discretionary authority, courts defer to a fiduciary’s interpretation unless it is so obviously wrong that the decision could not have resulted from any reasoning.

I agree with Peter that you could establish a more conservative interpretation, but it seems to me that the way IRS wrote the reg it would make distribution of the entire purchase price (plus gross-up for taxes) an "immediate and heavy financial need."

I'm not sure of the answer, and both arguments make sense to me.  But please remember that the latest regulations require that the employee provide to the plan administrator "a representation in writing ... that he or she has insufficient cash or other liquid assets reasonably available to satisfy the need."  So, if this person has a ton of money sitting in a bank account, he/she could not qualify for the entire $500,000 without some reason why that money was not available for the purchase.  Just something more to think about.

Here’s a follow-up question to sate our curiosity:

Imagine a plan’s employer/administrator instructed its service provider to decide hardship claims, without discretion, using a procedure designed to apply the regulation’s deemed needs and permitted assumptions.  The procedure also uses the Internal Revenue Manual’s method for processing claims using only the claimant’s written representations (without collecting supporting documentation).  All this is completely computerized.  The service provider has done a perfect job of implementing everything the regulation and the IRS method call for.  The claimant checks all the right boxes, and completes every “I certify” statement.  (Nothing in the plan’s records has information that, even if fully used, could reveal any lack of truthfulness in the claimant’s claim.)

Would the claim described above get routine processing through the system?

29 minutes ago, Peter Gulia said:

Here’s a follow-up question to sate our curiosity:

 

Pique?

7 hours ago, Peter Gulia said:

Would the claim described above get routine processing through the system?

Yes unless the software designer at some point said to him/herself, "You know, I just don't think that hardship distributions should ever be more than, say, $100k, so as a common sense check I will include a line of code in says that if the request is for > $100k, kick it out for manual processing." And then we are back to where we started, Peter.

Luke Bailey, thank you for an intriguing idea.

For a few service providers, I’ve designed non-discretionary claims-processing regimes—not only for hardship and unforeseeable-emergency claims, but also for other kinds.  For some kinds, a sensitive issue is specifying which conditions result in a kick-out to a discretionary reader.

In developing the method for deciding a hardship claim using what the IRS calls a “summary of information on source documents”, the IRS could have set an upper limit (for example, requiring a plan’s administrator to collect and consider source documents for a claim that would pay more than $nnn,nnn) but did not.  See Internal Revenue Manual 4.72.2.

Before presenting the memo at 2017’s TEGE conference, the IRS people had worked on this for at least 12 months.  They knew recordkeepers would make system changes grounded on the memo.  And they knew that for many plans tax law’s constraint is the only constraint.

For a hardship claim (if it does not require a spouse’s consent) under a typical individual-account retirement plan, no person has a direct economic stake in denying a claim.  The key restraint is a fear of losing the plan’s tax treatment.  If a plan’s claims procedure is within what the IRS’s employees are instructed not to challenge, there might be little or no reason to seek discretionary decision-making.  (I have seen administrators specify, or recordkeepers use, heightened identity controls for a claim that exceeds an amount threshold.)

My first post in this discussion described a way an administrator might decide against an unusual claim.  Some might want discretion to deny a claim.  And some, lacking an automated regime of the kind I described in my second post, might be stuck with discretion.

But an employer/administrator might consider whether it likes discretion (perhaps to help protect all or some participants from themselves), or whether it prefers not taking on any more discretion than is needed to obey public law and the plan’s governing documents.

On 10/6/2021 at 9:40 AM, BG5150 said:

Under your reasoning:

Someone may not "need" the entire amount for the semester tuition bill; they can just take a loan.

Someone may not "need" that facelift or tummy tuck, so it's not an acceptable hardship request.

 

 

The amount of a hardship distribution must be limited to the amount necessary to satisfy the need. This rule is satisfied if:

• The distribution is limited to the amount needed to cover the immediate and heavy financial need, and
• The employee couldn't reasonably obtain the funds from another source.

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-hardship-distributions

As a fiduciary, I don't think a trustee would be overstepping by asking if the participant has applied for a loan. Particularly for $500k.

Is a loan "another source"?

Does a participant have to utilize all credit avenues first?

Say they have $10,000 in the bank.  And $12,000 available across three credit cards.

If they get a medical bill for $20,000, how much of an hardship can they ask for?

Do they have to draw down the cash?  Cash they need for mortgage payments, maybe high school tuition, car payments, bills, etc?

Must they max out their credit cards first?

Maybe just a little cash and a little credit?

Should they apply for a HELOC?

Do the hardship regs still state the participant need not take counter-productive steps in obtaining alternate financing other than the hardship?

3 hours ago, 401king said:

As a fiduciary, I don't think a trustee would be overstepping by asking if the participant has applied for a loan. Particularly for $500k.

401king, whether fully intentionally or not, or well- or ill- advisedly or not, the new hardship regime does not require the participant to take any loan. See Treas. reg. 1.401(k)-1(d)(3)(iii)(B)(2), and contrast with Treas. reg. 1.401(k)-1(d)(3)(iii)(C), which makes plan loans optional and does not reference other types of loans. Moreover, the deemed hardship for home purchase (Treas. reg. 1.401(k)-1(d)(3)(ii)(B)(2) only requires that the distribution be directly related to the purchase of a home, not funding the down-payment. These provisions are intended as "safe harbors." They would not be safe if we have to read into them what the IRS might have wanted (but probably did not want) to say.