Hardship distribution provisions in 401(k) used to be one of those retirement plan matters on which plan sponsors didn’t spend a whole lot of time.
Lately, however, that’s not the case. From our vantage point, we’re seeing more requests for hardship distributions than ever before. That being the case, I’m going to take a few moments to discuss 401(k) hardships in the context of the current economic situation.
While hardship provisions, like loans, are allowed by law, employers are not required to provide for them in a 401(k) plan. Many do because they provide a sense of security to participants as they balance between retirement savings and current financial needs. In other words, a safety value in case they ever need the money for a financial security. And that time is now for many participants.
So is an overview of what constitutes a hardship and they should be administered. Hardship distributions from a 401(k) plan can be permitted under two general rules: safe harbor rules and general rules for an immediate and heavy financial need (more about that later).
Safe Harbor Rules
Under these rules, a hardship distribution would only be made upon the finding by the Plan Administrator of an immediate and heavy financial need where such Participant lacks other available resources. The IRS says the following are the only financial needs considered immediate and heavy:
Expenses for (or necessary to obtain) medical care that would be deductible under Code section 213(d) (determined without regard to whether the expenses exceed 7.5% of adjusted gross income);
- Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);
- 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, or the employee’s spouse, children, or dependents;
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence;
- Payments for burial or funeral expenses for the employee’s deceased parent, spouse, children or dependents;
- Expenses for the repair of damage to the employee’s principal residence that would qualify for the casualty deduction under Code section 165 (determined without regard to whether the loss exceeds 10% of adjusted gross income);
And Safe Harbor means exactly that. Follow the rules listed above, and a plan sponsor will automatically be in compliance with IRS regulations.
Under these rules, a hardship distribution shall only be made upon the finding by the Plan Administrator of an immediate and heavy financial need where such Participant lacks other available resources. But unlike the Safe Harbor rules, whether a Participant has an immediate and heavy financial need is determined based on all relevant facts and circumstances.
For example, the need to pay the funeral expenses of a family member would constitute an immediate and heavy financial need and a distribution made to a participant for the purchase of a boat or television would not constitute a distribution made on account of
an immediate and heavy financial need.
The General Rules for hardship provide flexibility for the employer to allow distributions based on the facts and circumstances of the employee and are not listed in the safe harbor rules. Whether that is desirable or not is another matter. This flexibility, however, is achieved only if the appropriate language is included in the plan.
So now finally, what exactly is an immediate and heavy financial need of an employee? IRS regulations say that a hardship distribution is deemed necessary to satisfy an immediate and heavy financial need of an employee if:
- The employee has obtained all other currently available distributions and loans under the plan and all other plans maintained by the employer;
- The employee is prohibited, under the terms of the plan or an otherwise legally enforceable agreement, from making elective contributions and employee contributions to the plan and all other plans maintained by the employer for at least 6 months after receipt of the hardship distribution (Safe Harbor only).
- Hardship distribution may not exceed the amount of the employee’s need. However, the amount required to satisfy the financial need may include amounts necessary to pay any taxes or penalties that may result from the distribution.
A withdrawal made by a 401(k) plan participant, either under general or safe harbor rules, is subject to heavy tax and penalty consequences and should therefore only be done as a last resort. And let’s hope that the "last resorts" don’t continue to be situations with which 401(k) participants are confronted.
For the official version of hardship distributions, here is a link to the IRS’ FAQs regarding hardship distributions.