Hardship Distributions from 401(k) Plans
October 2014 Newsletter
It's four o'clock on Friday afternoon and there's a knock
on the door of the Human Resource Manager's office. It's Zachary, a fairly new
employee who entered the company's 401(k) plan last month. He's been deferring
$40 a week into the plan, which means he has accumulated $160 by now. But last
night his cable TV was shut off because he couldn't afford to pay the bill and
from his 23-year-old point of view, retirement seems like a long way off.
He explained his situation to the H.R. Manager and asked if he could get his
deferrals back so he could reconnect the cable. After all, it was his money. The
H.R. Manager explained that under the terms of the plan the only type of
distribution available to someone younger than 59½ who is still employed is a
hardship distribution. Zachary's eyes lit up. "Yeah, a hardship distribution,"
he repeated. "That's what I want."
For this young man, living even one day without cable TV seemed like a
perfect example of a "hardship." But the Internal Revenue Code has a
somewhat different interpretation. What follows is a close-up look at the rules
concerning hardship distributions.
Does the Plan Permit Hardship
A defined contribution plan is not required to provide for in-service
distributions in the event of hardship. To permit hardship distributions,
appropriate language must be contained in the plan document. The type of
retirement plan most likely to offer hardship distributions is the ever-popular
401(k) plan, funded primarily by employee salary deferrals.
Because these accounts are funded by employees' own contributions, many
employers feel an obligation to make them available in times of need. It also
provides a feeling of security that may encourage participation which can help
increase allowable deferral limits for the highly compensated employees.
Hardship is the only allowable reason for an in-service distribution from salary
deferral accounts prior to age 59½.
Many profit sharing plans do not contain hardship provisions for
employer-funded accounts such as matching and profit sharing contributions. If
the employer chooses to allow hardship distributions from employer-funded
accounts, it has the discretion as to how hardship will be defined, unlike
salary deferral distributions which are subject to restrictive IRS requirements.
However, in order to simplify plan administration, some plan documents apply
the more restrictive salary deferral hardship withdrawal requirements to
hardship withdrawals from employer-funded accounts.
What Qualifies as a Hardship?
To receive a hardship distribution from salary deferral accounts, a plan
participant must have an "immediate and heavy" financial need that can't be met
in any other way.
The determination as to whether or not a participant has an immediate and
heavy financial need is based on all relevant facts and circumstances. However,
IRS regulations provide a safe harbor list of events which are automatically
deemed to satisfy the financial need requirement. Nearly all 401(k) plans
utilize the six IRS safe harbor events which are as follows:
- Certain unreimbursed medical expenses for the participant or the
participant's spouse, children, dependents or beneficiaries;
- Costs related to the purchase of a participant's principal residence,
excluding mortgage payments;
- Tuition, related educational fees and room and board expenses for up to
the next 12 months of post-secondary education for the participant or the
participant's spouse, children, dependents or beneficiaries;
- Payments necessary to prevent the eviction of the participant from the
participant's principal residence or foreclosure on the mortgage on that
- Burial or funeral expenses for the participant's parents, spouse,
children, dependents or beneficiaries; or
- Certain expenses to repair damage to the participant's principal
residence that qualify for the casualty loss deduction.
Reimbursement of casualty losses is a relatively new addition to the safe
harbor list. According to the IRS, casualty loss hardship distributions are
allowed for "the damage, destruction, or loss of property resulting from an
identifiable event that is sudden, unexpected or unusual..." This
definition includes occurrences like earthquakes, fires, floods, hurricanes,
tornadoes and terrorist attacks but not progressive deterioration such as a
steady weakening of a building due to normal wind and weather conditions or
The amount of the distribution cannot exceed the amount necessary to satisfy
the financial need but it may include amounts required to pay taxes and
penalties due on the distribution. For example, the participant cannot receive a
hardship distribution of $10,000 if only $2,000 is needed but can increase the
$2,000 amount needed to include estimated taxes and penalties.
Are Other Financial Resources Available
to the Participant?
Even if a participant can demonstrate an immediate and heavy financial need,
the participant must show that the need can only be satisfied by a withdrawal
from his or her salary deferral account and that the need cannot be satisfied by
other sources that are reasonably available to the participant.
Under the facts and circumstances test, a withdrawal will be deemed necessary
if the need cannot be satisfied from other sources, including sources reasonably
available to the participant from a spouse or minor child. Unless the plan
sponsor has actual knowledge to the contrary, the plan sponsor may rely on the
participant's written statement that the need cannot be relieved from other
available resources including:
- Reimbursement or compensation by insurance or otherwise;
- Liquidation of the participant's assets;
- Cessation of elective or other employee contributions to the plan;
- Other currently available distributions and loans from plans maintained
by any employer; or
- Borrowing from commercial sources on reasonable terms.
Any of the sources listed above will not be considered an available source if
it results in an increase in the amount of the financial need.
A plan can choose to utilize a safe harbor test in which case the
distribution will be deemed necessary to satisfy the need if both of the
following requirements are met:
- The participant has obtained all other currently available distributions
and loans from all plans maintained by the employer; and
- The participant is prohibited from making elective and other employee
contributions to any plan maintained by the employer for at least six months
after receipt of the hardship distribution (this suspension rule does not
apply to mandatory employee contributions to a defined benefit plan or to a
health or welfare benefit plan).
Plan Loans vs. Hardship Distributions
Plan sponsors may be confused by the requirement that all available plan
loans must be taken before becoming eligible for a hardship distribution. After
all, if the plan allows for loans, how can you justify approving the hardship
distribution without first requiring that the loan be taken? The IRS regulations
provide that any available loan not serve to merely increase the extent of the
In many situations the burden of loan repayments and additional debt on the
participant's credit report could worsen the participant's financial situation.
For example, the additional debt of a plan loan could disqualify a participant
from obtaining the mortgage needed to purchase a home.
What Funds are Available for Hardship
Different rules apply depending upon the source of funds being withdrawn:
Employee Deferral Accounts
Only the accumulated employee deferrals may be distributed—investment
earnings may not be distributed except for certain earnings accumulated in the
plan prior to 1989.
The plan may permit the entire vested employer-funded account balance to be
distributed, including earnings. Employer qualified nonelective contributions
(QNECs) and qualified matching contributions (QMACs) made for purposes of
passing nondiscrimination testing may not be distributed as in-service
distributions unless the employee has attained age 59½ (an exception applies for
QNECs and QMACs credited prior to 1989). Also, employer safe harbor 401(k)
contributions may not be distributed.
The IRS expects the plan sponsor to require proof of financial need before
authorizing a hardship distribution from the plan. Simply relying on the reason
that is checked on the hardship request is not enough. Proof may include copies
of medical bills and insurance statements, past due notices from the landlord or
mortgage company, copies of college tuition bills, etc.
The ability to request hardship distributions electronically is growing in
popularity. During this process, participants self-certify that they meet the
hardship criteria. The IRS has made it clear that electronic self-certification
does not relieve the plan sponsor of the need to gather documentation of the
immediate and heavy financial need.
It is important that the plan sponsor retain a record of all information used
to determine whether a participant was eligible for a hardship distribution and
the amount distributed was the amount necessary to alleviate the hardship. If
the plan is audited by the IRS, the agent will look for this documentation.
Hardship distributions are taxable in the year received and are includible in
gross income unless they consist of designated Roth contributions. In addition,
they may be subject to an additional 10% early withdrawal penalty if the
participant has not reached age 59½. Hardship distributions are not eligible for
rollover to an IRA or another qualified plan and may not be repaid to the plan.
Hardship distributions are a valuable component of many 401(k) plans. They
encourage participation in the plan and provide a sense of security to
participants as they seek a balance between retirement savings and current
Authorizing plan distributions that do not satisfy the IRS hardship
requirements can result in plan disqualification and adverse tax consequences
for the participants and the plan sponsor. Therefore, it is important for plan
sponsors to understand the hardship distribution requirements and to make sure
their hardship distribution paperwork is in order.
This newsletter is intended to provide general
information on matters of interest in the area of qualified retirement plans and
is distributed with the understanding that the publisher and distributor are not
rendering legal, tax or other professional advice. Readers should not act or
rely on any information in this newsletter without first seeking the advice of
an independent tax advisor such as an attorney or CPA.