Follow Hardship Distribution Rules to Keep Plan Status
While many employees today understand the importance of retirement readiness, some plan participants may seek a 401(k) hardship distribution to accommodate crucial, more immediate needs. If your retirement plan includes this optional provision, make sure it fulfills all necessary U.S. Internal Revenue Service rules and requirements to maintain your qualified plan status.
According to the IRS Do’s and Don’ts of Hardship Distributions, a withdrawal can only be made if the following criteria are met:
- The 401(k) retirement plan permits a hardship distribution.
- There is an “immediate and heavy financial need” by the employee and, in some cases, by the employee’s spouse, dependent or beneficiary.
- The amount is only for the immediate need. However, in the Retirement Plans FAQs Regarding Hardship Distributions document, the IRS does note that the distribution total can include “amounts necessary to pay any taxes or penalties that may result from the distribution.”
Your plan must clearly state the process used for determining hardship distributions and it must meet nondiscriminatory and objective standards. The types of hardship circumstances allowed, must also be noted, and according to the IRS can include the following:
- Medical expenses
- Home purchasing costs
- Educational fees and tuition
- Payments necessary to avoid foreclosure or eviction from a primary residence
- Funeral expenses
- Damage or repair to a primary residence
Distributions from a 401(k) plan can only come from employee deferral contributions and typically cannot include earned income. Most plans prohibit employee plan contributions for six months following a hardship distribution. The distributions must be included in gross income (unless part of a Roth) and they may be subject to additional taxes for early withdrawal.
According to the IRS, plan sponsors must ensure that the criteria for hardship distribution is carefully followed and that the process is correctly managed by plan administrators and payroll.
Before making distributions, the IRS Do’s and Don’ts of Hardship Distributions recommends plan sponsors take the following steps:
- Review the hardship distribution stipulations in the plan document.
- Obtain and review an employee’s request statement to determine if it meets the criteria.
- Determine and document if the employee has “exhausted any loans or distributions, other than hardship distributions, that are available from the plan or any other plan of the employer in which the employee participates.”
- If required by the plan criteria, document that funds from a spouse or minor child are not available.
- Verify the fund amount needed to meet the hardship circumstances and make sure the amount falls within any possible limits set by the plan.
As with all aspects of a retirement plan, employers should thoroughly document any hardship distributions and regularly monitor the process.
We all know employees can face unforeseen expenses and emergencies. If you elect to include a hardship distribution in your 401(k) plan, just make sure it is properly prepared and followed to maintain your plan’s qualified status.
The opinions voiced in this material are for general information only and are not intended as authoritative guidance or tax or legal advice. You should consult with your attorney or advisor for guidance on your specific situation.