Riddle Me This: Why Offer a Hardship Withdrawal Option?
Plans that do not offer a hardship withdrawal option are still subject to “plan leakage.” In other words, employees’ retirement dollars prematurely leave the plan due to hardship withdrawals, plan loans going into default upon employment termination or other reasons. Whatever the cause of the leakage, withdrawals affect employees when they retire.
To discourage employees from tapping into retirement assets for instances outside the direst of circumstances, sponsors may decide to forego a hardship withdrawal option, particularly if their plans have a loan option. On the other hand, plan sponsors who believe employees (current and prospective) will see the lack of a hardship withdrawal provision as a negative may want to consider offering that choice.
Deciphering “Immediate and Heavy” Needs
The rule governing hardship withdrawals requires that the employee make the withdrawal to satisfy only an “immediate and heavy” financial need as defined in the rule. The withdrawal may benefit the employee’s spouse, minor children, or nondependent beneficiary. 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.
The plan sponsor must determine whether a requested hardship withdrawal is justified based on the following:
- the IRS’ rules,
- plan provisions, and
- the sponsor’s assessment of the situation.
Sponsors can rely on a participant’s written statement that s/he has no alternative means of addressing the financial need – unless there is evidence to the contrary (note: the regulations provide examples of this knowledge). Sponsors may also outsource this process to their third-party administrators (while maintaining responsibility).
The IRS requires plan sponsors to keep track of all documents related to an employee’s hardship withdrawals and plan loans. Learn more about how sponsors can fulfill this responsibility.
Decoding Eligible Expenses
Under the safe harbor definition of hardship withdrawal, several expense categories are automatically eligible, 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 withdraw amounts consisting only of contributions to the employee’s 401(k) account, not earnings on those contributions. For funds derived from employee deferrals, sponsors 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. Employees who take withdrawals before age 59½ may also be subject to a 10% premature-withdrawal tax penalty.
Playing “Spot the Difference” with Program Administration Errors
What happens to sponsors who make a mistake in administering a hardship withdrawal program? The consequences depend on the error. For example, a sponsor who was allowing hardship withdrawals but discovered that the plan document does not provide for them should amend the plan, make the amendment retroactive, and then seek approval for that action through the IRS’ “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, sponsors would also need to retroactively amend their plans through the VCP.
Another common hardship withdrawal error is failing to suspend plan contributions for at least six months following the withdrawal. The IRS offers two possible solutions:
- 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 option guarantees that the employee will be in the same position as s/he would have been in had the contributions been suspended immediately following the hardship withdrawal. An employee would be in that position if, for instance, a sponsor 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 sponsor must address the error.
Putting Together the Pieces of Your Hardship Withdrawal Program Administration
Read your plan document to refresh yourself on the nuances of your hardship withdrawal requirements. Make sure that anyone administering your plan — either in-house or a third-party administrator — does the same. A thorough review will go a long way in striving to avoid mistakes. Contact CRI if you need help connecting the dots with your hardship withdrawal program.