Hardship 401(k) Distributions – Frequently Asked Questions
A 401(k) plan may, but is not required to, allow participants to take a hardship distribution in times of financial stress. This type of 401(k) distribution can be a financial lifeline when someone has nowhere else to turn for cash. Last year, the IRS released a proposed regulation that made several changes to the 401(k) hardship rules, generally relaxing how and when these distributions may be taken. Both employers and 401(k) participants should understand how the regulation will affect their retirement plan.
Employers don’t really have a choice. After all, they have a fiduciary responsibility to administer their 401(k) plan in accordance with the law. Meeting this responsibility is important because severe consequences – including plan disqualification or fiduciary liability – are possible when it’s not. To stay out of trouble, employers must be ready to administer the new hardship rules.
We receive a lot of questions from clients about hardship distributions – which is hardly surprising when you consider how complicated these rules can appear. These questions increased dramatically after the IRS proposed hardship changes. Below is a FAQ with answers to the most common questions we receive.
Are 401(k) plans required to permit hardship distribution?
No, 401(k) plans are not obligated to offer participants access to hardship distributions.
How does a 401(k) participant qualify for a hardship distribution?
To qualify for a hardship distribution, a 401(k) participant must meet two criteria. First, they must have an “immediate and heavy financial need.” Second, the distribution must be limited to the amount “necessary to satisfy” the financial need.
What’s an immediate and heavy financial need?
401(k) plans have two options for defining an “immediate and heavy financial need:” 1) use the IRS safe harbor definition, or 2) use a custom definition. Most 401(k) plans choose the safe harbor option. It specifies six events that are automatically considered as an immediate and heavy financial need:
- Medical care expenses for the employee, the employee’s spouse, dependents or beneficiary.
- Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments).
- Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary.
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
- Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
- Certain expenses to repair damage to the employee’s principal residence.
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What’s the amount necessary to satisfy the financial need?
Hardship distributions must be limited to the amount necessary to satisfy the need. This rule is satisfied if:
- The distribution is limited to the amount needed to cover the “immediate and heavy financial need,” including any taxes or penalties that may result from the distribution.
- The employee could not reasonably obtain the funds from another source.
Unless the employer has actual knowledge to the contrary, they may rely on the employee’s written statement that their need can’t be relieved from other available resources, including:
- Insurance or other reimbursement.
- Liquidation of the employee’s assets.
- The employee’s pay, by discontinuing elective deferrals and after-tax employee contributions.
- Plan loans or reasonable commercial loans.
What documentation is necessary to substantiate a hardship request?
When the safe harbor definition of immediate and heavy financial need is used by a 401(k) plan, employers have two options for “substantiating” a hardship distribution – basically, confirming the participant’s hardship request meets the plan’s need and amount requirements.
- Traditional substantiation method – obtain the actual source documents that substantiate the need for the distribution. This is the only option for non-safe harbor hardships.
- Summary substantiation method – rely on a participant-provided summary of the financial hardship, provided that the summary contains certain information.
Regardless of method used, hardship documentation must be retained in accordance with ERISA’s documentation retention rules.
What are the consequences for taking a hardship distribution?
Taking a hardship distribution can be costly. Not only are they taxable at personal income rates, but most participants under age 59 ½ will pay an additional 10% early distribution penalty. Further, hardship distributions can’t be repaid or rolled to another retirement plan. That means the amount distributed will miss out on future earnings. Due to the power of compound interest, these lost earnings can become substantial over time.
In short, taking a hardship distribution should be a last resort.
What changes would the proposed hardship regulation make?
In general, the proposed regulation relaxes the hardship distribution rules. Below are the key changes. They can be implemented in operation as soon as the first day of the 2019 plan year; however, most employers will likely wait until final hardship regulations are released to implement.
- Under current IRS regulations, 401(k) participants are generally prohibited from making employee contributions for six months following the receipt of a hardship distribution. The proposed regulation removes this six-month suspension rule. This change is mandatory for hardship distributions occurring on or after January 1, 2020.
- Under current IRS regulations, certain 401(k) contributions sources are unavailable for hardship distribution - including QNECs, QMACs, safe harbor contributions, and earnings on elective deferrals. The proposed regulation makes all contribution sources available for hardship distribution. Implementing this change is optional, not mandatory.
- Under current IRS regulations, 401(k) participants must generally take a loan before taking a hardship distribution. The proposed regulation eliminates this requirement. Implementing this change is optional, not mandatory.
- Under current IRS regulations, employers must consider all relevant facts and circumstances when determining whether a hardship distribution is limited to the amount necessary to satisfy the For hardship distributions occurring on or after January 1, 2020, the proposed regulation permits employers to rely on a written representation from the participant that represent that “he or she has insufficient cash or other liquid assets to satisfy the financial need” – assuming the employer has no actual knowledge to the contrary.
- Under the current IRS regulations, there are six safe harbor events that automatically qualify as an “immediate and heavy financial need.” The proposed regulation adds a seventh - expenses resulting from a federally declared disaster.
401(k) plans that permit hardship distributions must be formally amended to reflect the changes.
What’s the deadline for amending a 401(k) plan for hardship changes?
The amendment deadline won’t be known until the final hardship regulation is released. However, it appears employers can rely on the proposed regulation if they want to implement the changes in operation prior to formal plan amendment.
401(k) hardship rules are manageable with the right help!
Both employers and employees should understand their 401(k) plan’s hardship distribution rules. At first blush, these rules can seem extremely complicated. In truth, however, most can be understood with some basic education. After all, 401(k) participants just need to meet two criteria to qualify for a distribution. In general, these rules were relaxed by the IRS’ proposed hardship regulation.
Got further questions? Ask your 401(k) provider. An experienced provider should be able to help with straightforward guidance.
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About Eric Droblyen
Eric Droblyen began his career as an ERISA compliance specialist with Charles Schwab in the mid-1990s. His keen grasp on 401k plan administration and compliance matters has made Eric a sought after speaker. He has delivered presentations at a number of events, including the American Society of Pension Professionals and Actuaries (ASPPA) Annual Conference. As President and CEO of Employee Fiduciary, Eric is responsible for all aspects of the company’s operations and service delivery.