United States: How To Handle Hardship Withdrawals

Last Updated: July 24 2017
Article by Stephanie Zaleski

Many 401(k) plans feature a hardship withdrawal option. Both the IRS and DOL maintain strict regulations around these provisions. In early 2017, the IRS issued updated audit guidelines regarding requirements for hardship withdrawals and guidance for plan sponsors on how to remedy errors in the administration of these withdrawals.

Why Should You Give Participants the Option?

Even if your plan does not allow hardship withdrawals, it is still subject to "plan leakage": Pre-retirement reductions in plan savings by employees, through loans, hardship withdrawals or payouts when changing jobs. According to the Transamerica Center for Retirement Studies survey in December 2016, 27% of workers who currently participate in a qualified plan have taken some form of a loan, early withdrawal or hardship withdrawal from their plan. Plan leakage affects employees when they retire.

Consider foregoing a hardship withdrawal option to keep employees from taking a distribution from their retirement savings, especially if you offer loans. Although a hardship option may be seen as an attractive option for current and prospective employees.

Is a Hardship Necessary?

The IRS code that governs hardship withdrawals states that a withdrawal may be taken only if it is due to an immediate and heavy financial need (including the employee's spouse and minor children or non-dependent beneficiary). The withdrawal must be necessary to satisfy that need (you have no other funds to meet the need), and you have exhausted all other resources including having obtained all non-taxable loan options available under the plan. Once a distribution is taken, a participant may not contribute to the 401(k) plan for six months.

Even if you use a third party administrator (TPA), a plan sponsor is ultimately responsible in determining whether or not a requested hardship withdrawal is justified based on the IRS and DOL rules. 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. According to the IRS, records of the following should be kept:

  1. Documentation of the request, review and approval;
  2. Financial information and documentation that substantiates the employee's immediate and heavy financial need;
  3. Documentation to support the hardship withdrawal was made properly according to IRS provisions;
  4. Proof of the actual distribution made and Form 1099-Rs.

Eligible Expenses

The following expenses are eligible for hardship withdrawals.

  • Medical expenses for the employee, spouse or child;
  • Costs relating to the purchase of a principal residence;
  • Tuition and related educational fees and expenses for the participant, spouse, child or beneficiary;
  • Payments necessary to prevent eviction from or foreclosure on a principal residence;
  • Burial or funeral expenses for the participant, spouse, child or beneficiary;
  • Certain expenses for the repair of damage to the employee's principal residence.

The participant can only withdraw amounts consisting of contributions to the employee's 401(k) account, not earnings on those contributions.

Generally, hardship withdrawals, unless taken from a Roth 401(k) plan, are taxable. Also, if taken before age 59˝, they may also be subject to a premature-withdrawal 10% tax penalty.

Administration Errors

What happens if the plan sponsor makes a mistake in administering hardship withdrawals? Different mistakes can be made, so appropriate remedies must be sought out for each mistake. One mistake that can be made is allowing hardship withdrawals even though the plan document does not allow them. In this case, the plan needs to be retroactively amended to allow for hardship distributions. The plan then needs to seek approval for that action through the IRS's "voluntary compliance program" (VCP). More information about the VCP can be found on the IRS's website.

Another mistake that may be made is granting a hardship withdrawal for a purpose not specifically provided for in the plan document. In this situation, you would also need to amend your plan retroactively through the VCP.

A common hardship withdrawal error is not suspending participant contributions for six months following the distribution. 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.

The problem with suspending deferrals "going forward" is that the employee may lose out if the plan's matching contribution is changed in the interim. The earnings could also be negatively affected. On the other hand, having an employee return a distribution could be difficult if it was already spent. One way or another, however, the error must be addressed.

How to Avoid the Mistake

In order to avoid administration errors, plan sponsors should review the plan document language to determine the circumstances under which distributions can be made. Make sure that anyone administering the plan also reviews the plan document – anyone in-house or a third-party administrator. Establish hardship distribution procedures to ensure sufficient information is gathered. Only allow hardship distributions that meet the plan document. If an expense is in question, reach out to the third-party administrator or your plan auditors for further clarification. Make sure the hardship distribution program is not being abused by any employees. If a participant is taking multiple hardship distributions a year, make sure each situation has its own individual circumstance. These steps will ensure the program is being handled appropriately.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Stephanie Zaleski
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