Although not required, most 401(k) plans feature a hardship withdrawal option. The IRS maintains strict rules surrounding these provisions and recently updated its guidance on how plan sponsors can remedy errors in the administration of hardship withdrawals.
Why have the option?
What if your plan doesn’t offer a hardship withdrawal option? It’ll still be subject to “plan leakage”: employees’ retirement dollars leaving your plan prematurely, whether due to hardship withdrawals or other reasons, such as plan loans that go into default on an employee’s termination of employment. Whatever the reason for the leakage, withdrawals affect employees when they retire.
To discourage employees from tapping into retirement assets for reasons other than under the most dire of circumstances, consider forgoing a hardship withdrawal option, particularly if you have a loan option. On the other hand, if you believe the lack of a hardship withdrawal provision will be seen by employees — and prospective employees — as a negative, you may want to consider offering hardship withdrawals.
Is the need immediate and heavy?
The rule governing hardship withdrawals requires that the withdrawal be made to satisfy only an “immediate and heavy” financial need of the employee (including the employee’s spouse and minor children or nondependent beneficiary) as defined in the rule. In addition, the sum is limited to the amount that cannot be met from other sources. Those could include savings; a plan loan or any other kind of loan; or increasing the participant’s paycheck by suspending 401(k) deferrals.
As the plan sponsor, you must determine whether a requested hardship withdrawal is justified, based on IRS rules, your plan provisions and your assessment of the situation. You can rely on a participant’s written statement that he or she has no alternative means of addressing the financial need, unless you have evidence to the contrary (the regulations set out examples of this knowledge), and you may outsource this process to your third party administrator (while maintaining responsibility).
What expenses are eligible?
Under the safe harbor definition of hardship withdrawal, there are several expense categories that are automatically eligible for a hardship withdrawal, including:
- Medical expenses for the employee, spouse or child,
- Costs directly related to the purchase of a principal residence (except mortgage payments),
- Funds needed to prevent eviction from a rented property or foreclosure on a primary residence,
- The cost of repairing damage to a principal residence,
- Tuition and related postsecondary school educational expenses for the next year for the participant or a spouse, child or beneficiary, or
- Funeral expenses for the employee, spouse, child or beneficiary.
The participant can only withdraw amounts consisting of contributions to the employee’s 401(k) account, not earnings on those contributions. For funds derived from employee deferrals, you can apply withdrawal standards that are different from those stemming from employer-matching or nonelective contributions (such as profit sharing contributions).
Plan documents generally require that participants not resume elective deferrals for at least six months after the hardship withdrawal. Generally, hardship withdrawals, unless taken from a Roth 401(k) plan, are taxable. Also, if taken before age 59½, they may also be subject to a premature-withdrawal 10% tax penalty.
How can you fix errors?
What happens if you make a mistake in administering a hardship withdrawal program? That depends on the mistake. For example, if you were allowing hardship withdrawals but discovered that your plan document doesn’t provide for them, you need to amend your plan, make the amendment retroactive, and then seek approval for that action through the IRS’s “voluntary compliance program” (VCP).
In a more typical scenario, a mistake would be made by granting a hardship withdrawal for a purpose not specifically provided for in the plan document. In that situation, you would also need to amend your plan retroactively through the VCP.
Another example of a common hardship withdrawal error identified by the IRS is failing to suspend plan contributions for at least six months following the withdrawal. The IRS offers two possible options to remedy that error:
- Suspend employee deferrals for a six-month period “going forward,” or
- Have the employee return the hardship distribution.
The catch, according to the IRS, is that neither of the options guarantees to put the employee in the same position as he or she would have been in had the contributions been suspended immediately following the hardship withdrawal. This would be true, for example, if you changed the plan’s matching contribution in the interim or if the employee lacked the funds to return the distribution. One way or another, however, the error must be addressed.
Plan for withdrawals now
Read your plan document to refresh yourself on the intricacies of your hardship withdrawal requirements. Make sure that anyone administering your plan — either in-house or a third-party administrator — do the same. This will go a long way toward avoiding mistakes in the first place.