Hardship Withdrawal Programs Require Strict Administration

If your 401(k) plan features a hardship withdrawal option be aware that the IRS recently updated its guidance on how plan sponsors can remedy errors in the administration of hardship withdrawals.

Why Have the Hardship Withdrawal Option?

Though your plan may choose not to have a hardship withdrawal option, it still may be subject to “plan leakage.”  Plan leakage is defined as when employees’ retirement dollars leave the plan prematurely, whether due to hardship withdrawals or other reasons, such as plan loans that go into default upon an employee’s termination of employment. No matter the reason for the leakage, withdrawals affect employees when they retire.

It is suggested, that if your plan has a loan option, then you may wish to consider foregoing a hardship withdrawal option in order to discourage employees from tapping into retirement assets for reasons other than under the most dire of circumstances.  However, understand that some employees and prospective employees may deem this as a negative.

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 sources could include savings; a plan loan or any other kind of loan; or increasing the participant’s paycheck by suspending 401(k) deferrals.

It is the plan sponsor’s responsibility to determine whether a requested hardship withdrawal is justified, based on IRS rules, plan provisions and an assessment of the situation.  In order to assist plan sponsor’s in making this judgement you can: (1) 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), or (2) you may outsource this process to your third-party administrator (while maintaining responsibility).

What Expenses are Eligible?

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.

It is important to remember that 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).

For those participants that elect to take a hardship withdrawal, participants usually may not resume elective deferrals for at least six months after the hardship withdrawal. In general, hardship withdrawals are taxable (if taken before age 59 1/2, they may also be subject to a premature withdrawal 10% tax penalty) unless taken from a Roth 401(k) plan.

How Can You Fix Errors?

What happens if you make a mistake in administering a hardship withdrawal program?

Scenario #1: if you were allowing hardship withdrawals, but discovered that your plan document doesn’t provide for them, you need to (1) amend your plan,  (2) make the amendment retroactive, and (3) then seek approval for that action through the IRS’s “voluntary compliance program” (“VCP”).

Scenario #2: if you granted a hardship withdrawal for a purpose not specifically provided for in the plan document, then, you would also need to amend your plan retroactively through the VCP.

Scenario #3: if you failed to suspend plan contributions for at least six months following a hardship withdrawal, then the IRS offers two possible options to remedy that error:

  1. Suspend employee deferrals for a six-month period “going forward,” or
  2. Have the employee return the hardship distribution.

Plan for Withdrawals Now

Some helpful suggestions to avoid mistakes are to: (1) read your plan document to refresh yourself on the intricacies of your hardship withdrawal requirements, and (2) make sure that anyone administering your plan — either in-house or a third-party administrator — do the same.

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