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. In 2019, the IRS released a final hardship rule that made several changes to the 401(k) hardship rules, generally relaxing how and when these distributions may be taken. In 2022, Congress passed the SECURE 2.0 law which also released how 401(k) hardship 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. 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 seven 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.
- Expenses resulting from a federally declared disaster (added by the 2019 final rule).
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, beginning in 2023, employers may rely on a written representation from the participant confirming the hardship request meets the plan’s need and amount requirements. This self-certification is permitted as long as the employer has no actual knowledge to the contrary. The employer may also use one of two other methods if desired:
- Traditional substantiation method – obtain the actual source documents that substantiate the need for the distribution.
- 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 did the 2019 final hardship rule make?
On Sept. 23, 2019 the IRS released a final hardship rule that relaxed several hardship distribution restrictions. Some of these changes are mandatory, requiring employers to make the changes by Jan. 1, 2020, while others are optional. Below are the key changes.
- Under prior IRS regulations, 401(k) participants were generally prohibited from making employee contributions for six months following the receipt of a hardship distribution. The new rule removes this six-month suspension rule. This change is mandatory for hardship distributions occurring on or after January 1, 2020.
- Under prior IRS regulations, certain 401(k) contributions sources were unavailable for hardship distribution - including QNECs, QMACs, safe harbor contributions, and earnings on elective deferrals. The new rule makes all contribution sources available for hardship distribution. Implementing this change is optional, not mandatory.
- Under prior IRS regulations, 401(k) participants generally had to take a loan before taking a hardship distribution. The new rule eliminates this requirement. Implementing this change is optional, not mandatory.
- Under prior IRS regulations, employers had to consider all relevant facts and circumstances when determining whether a hardship distribution is limited to the amount necessary to satisfy the participant's need. For hardship distributions occurring on or after January 1, 2020, the new rule 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 prior IRS regulations, there were six safe harbor events that automatically qualify as an “immediate and heavy financial need.” The new rule added 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 changes did SECURE 2.0 make?
On Dec. 29, 2022, Congress passed the SECURE 2.0 law that changed certain hardship distribution restrictions. Below is the key change for 401(k) plans which is effective in 2023.
- Under prior IRS regulations, employers had to confirm the participant’s hardship request meets the plan’s need and amount requirements through either the traditional substantiation method or the summary substantiation method. For hardship distributions occurring in 2023, the new law permits employers to rely on a written representation from the participant assuming the employer has no actual knowledge to the contrary.
What’s the deadline for amending a 401(k) plan for hardship changes?
401(k) plans that permit hardship distributions needed to be amended to reflect the new rules by Dec. 31, 2021, as operational changes to comply with the new regulations began on Jan. 1, 2020.
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’ final hardship regulation.
Got further questions? Ask your 401(k) provider. An experienced provider should be able to help with straightforward guidance.