Hardships and Your Plan Document
The IRS does not require qualified retirement plans, such as 401(k)s and 403(b)s, to allow for hardship withdrawals. If they do allow such withdrawals, they use one of two hardship methods:
Safe Harbor. Under “safe harbor” hardship rules, the IRS allows hardship withdrawals for:
Certain medical care expenses
Costs directly related to the purchase of a principal residence
Tuition and related educational fees and expenses
Payments necessary to prevent eviction from (or foreclosure on) a principal residence
Certain expenses for the repair of damage to the employee’s principal residence
Facts and Circumstances. Under the facts and circumstances rule, the plan sponsor determines whether the expense qualifies based on the IRS hardship definition of immediate and heavy need. However, this offers less protection to a plan sponsor, so the sponsor should consider requiring the six IRS “safe harbor” reasons.
The plan sponsor determines whether a request qualifies as a hardship under the plan provisions. Ask the participant to provide documentation to verify the need and the amount requested. This may be an invoice, a past due billing statement or notice, or a letter from a financial institution or business. Review the documentation to ensure its validity and keep a copy in the employee’s file for audit purposes.
Hardships and Other Financial Resources
Plan sponsors may rely on an employee’s representation that he or she has exhausted all other monetary sources unless the plan sponsor has actual knowledge that this is not the case. For example, a hardship distribution is not permitted if the participant can obtain funds:
Through reimbursement or compensation from insurance
By liquidation of the employee’s assets
By stopping elective contributions or employee contributions under the plan
By other available distributions (such as plan loans or in-service distributions) under plans maintained by this employer or any other
By borrowing from commercial sources
However, a participant is not obligated to take counterproductive actions. For instance, obtaining a plan loan is not required if it would prevent the participant from obtaining additional financing for a home purchase.
Consider implementing an internal hardship application with a participant’s signature. The application may include items such as the reason for the hardship and verification that the applicant has exhausted all other available means. Retain a copy for your records.
Making Hardships Work
Plan sponsors should remind participants that, if they are under age 59½, they will owe a 10% early withdrawal penalty in addition to any taxes they owe on the distribution. Hardships are heavily regulated. This article covers only some of the requirements. Make sure you understand your plan’s hardship requirements. Can you confidently say that all your hardship distribution paperwork is in order? Take the time to evaluate whether your plan is set up to minimize any operational risks and, if not, contact your plan auditor or plan consultant for assistance.
Sandy P. Purdy, CPA, is a senior manager in Lindquist LLP’s San Ramon office. She has spent more than 14 years in public accounting, working with employee benefit plans of various sizes, complexities and structures. She performs both full and limited-scope audits of more than 25 defined contribution and defined benefit plans with more than $400 million in total assets.