IRS Logo
Print - Click this link to Print this page

401(k) Plan Fix-It Guide - Hardship distributions weren't made properly

Mistake

Find the Mistake

Fix the Mistake

Avoid the Mistake

10) Hardship distributions weren't made properly. Review all in-service distributions and determine whether  hardship distributions met the plan requirements. Amend plan retroactively to allow for hardship distributions. If impermissible hardship distribution, have participant return hardship distribution amount plus earnings. Be familiar with your plan document’s hardship provisions and ensure that you follow the provisions in operation. Ensure that your plan administrators and payroll offices share the plan’s hardship distribution information.

A 401(k) plan may allow employees to receive a hardship distribution because of an immediate and heavy financial need. Hardship distributions from a 401(k) plan are limited to the amount of the employee’s elective deferrals and generally don't include any income earned on the deferred amounts. The employee can't roll over hardship distributions to another plan or IRA. The law treats a distribution as a hardship distribution only if it's made both because of an employee's immediate and heavy financial need and is necessary to satisfy that financial need. The employer determines whether an employee has an immediate and heavy financial need based on all relevant facts and circumstances; however, the law deems a distribution to be made because of an employee's immediate and heavy financial need if the distribution is for:

  • Medical care expenses previously incurred by the employee, the employee’s spouse or any dependents of the employee, or if necessary for these persons to obtain medical care;
  • Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);
  • Payment of tuition, related educational fees, and room and board expenses for the next 12 months of post-secondary education for the employee, the employee’s spouse, children or dependents;
  • Payments necessary to prevent the eviction of the employee from the employee’s principal residence or mortgage foreclosure on that residence;
  • Funeral expenses for the employee’s deceased parent, spouse, etc.; or
  • Certain expenses relating to the repair of damage to the employee’s principal residence.

Nearly all 401(k) plans contain these conditions for determining whether a distribution is necessary to satisfy an employee’s immediate and heavy financial need. These rules relieve the employer (and the employee) from looking at resources outside the 401(k) plan.

A hardship distribution described in the first, third and fifth bullets, above, can be made to a participant based on a grandchild’s or domestic partner’s need if that individual has been designated as a plan beneficiary, if this option is included in your plan document.

You may not treat a distribution as necessary to satisfy an immediate and heavy financial need:

  • if the distribution exceeds the amount needed to relieve the employee’s financial need, or
  • if the financial need may be satisfied from other resources reasonably available to the employee.

You generally make this determination based on all relevant facts and circumstances. The law deems the employee’s resources to include those assets of the employee’s spouse and minor children that are reasonably available to the employee. Thus, for example, a vacation home owned by the employee and the employee’s spouse generally will be deemed a resource of the employee. The amount of an immediate and heavy financial need may include any amounts necessary to pay any federal, state or local income taxes or penalties that reasonably result from the distribution.

You generally may treat an immediate and heavy financial need as not capable of being relieved from other resources reasonably available to the employee if you rely on the employee’s written representation, unless you have actual knowledge to the contrary, that the need can't reasonably be relieved:

  • through reimbursement or compensation by insurance or otherwise;
  • by liquidating the employee’s assets;
  • by ceasing elective deferrals or employee contributions under the plan; or
  • by other distributions or nontaxable loans from plans maintained by the employer or by any other employer, or by borrowing from commercial sources on reasonable commercial terms in an amount sufficient to satisfy the need.

A need can't reasonably be relieved by one of the actions listed above if the effect would be to increase the amount of the need. For example, a plan loan can't reasonably relieve the need for funds to purchase a principal residence if the loan would disqualify the employee from obtaining other necessary financing.

It’s important that you keep a record of all information used to determine whether a participant was eligible for a hardship distribution and the amount distributed was the amount necessary to alleviate the hardship.

Hardship distributions may be subject to the 10% early distribution tax on distributions made prior to reaching age 59 ½.

How to find the mistake:

Review your plan document to determine if it allows hardship distributions, then review your 401(k) plan hardship procedures. If you don’t have procedures for reviewing hardship applications, establish them possibly with the help of a benefits professional.

Review all distributions made during the year and determine which may have been a hardship distribution. For each hardship distribution, make a determination whether each one met the hardship distribution requirements in the plan document. Look for abuse of the hardship feature. If most of your hardship requests come from a specific group of employees, you may have some participants abusing the hardship feature.

How to fix the mistake:

Corrective action:
If  the plan document doesn't allow for hardship distributions, but, in operation, hardship distributions do occur, correction may involve a retroactive amendment to allow hardship distributions and if hardship distributions are made to participants that don’t meet the plan document hardship requirements or the 401(k) rules, then correction may involve a repayment to the plan of the amounts that didn't meet the plan hardship requirements or Section 401(k).

Example 1:
Employer L maintains a 401(k) plan with 40 participants. Plan provisions don't allow for hardship distributions. Employer L made hardship distributions to some employees during the 2011 and 2012-plan years. During a review of its plan operations, Employer L determined that it had made these hardship distributions available to all employees and that it had met the rules for hardship distributions.

Correction programs available:

Self-Correction Program
This mistake is considered an operational error. If L determines it has established practices and procedures in place to promote the overall compliance of their plan, it may correct the mistake under SCP. Although, in general, correction of an operational error through plan amendment isn't permissible under SCP, the provision of hardship withdrawals under the plan in a nondiscriminatory manner is one of four instances in which EPCRS allows a corrective amendment under SCP.

Correction would include adopting a retroactive plan amendment, effective January 1, 2011, to provide for the hardship distributions that Employer L made available. The amendment must provide that the hardship distribution option is nondiscriminatory.

Voluntary Correction Program
Employer L may also correct the mistake under VCP by adopting a retroactive plan amendment, effective January 1, 2011, to provide for the hardship distributions it made available. The amendment must provide that the plan make the hardship distribution option nondiscriminatory. The fee for the VCP submission, based on a 40-person plan is $1,000. When L makes its VCP submission, it must include Forms 8950 and 8951 and should consider using the model documents in Revenue Procedure 2013-12 Appendix C.   

Audit Closing Agreement Program
Employer L may also correct this error under Audit CAP (see example 3).

Example 2
Same facts as Example 1, except Employer L didn't make the distributions available to all employees and only made a hardship distribution to an HCE.

Correction programs available:

Self-Correction Program:
Since Employer L didn't make hardship distributions available to all employees, correction by retroactive amendment under SCP isn't available. An alternative correction that's reasonably designed to comply with section 6 of Revenue Procedure 2013-12 will be permitted.

Voluntary Correction Program
Employer L may correct the mistake under VCP. However, since Employer L didn't make the hardship distributions available to all employees and only made them available to select highly compensated employees, EPCRS doesn't permit a retroactive plan amendment to correct this mistake because it won't satisfy the nondiscrimination rules. An alternative correction that's reasonably designed to comply with section 6 of Revenue Procedure 2013-12 will be permitted. The  fee for the VCP submission in this case is $1,000. 

Audit Closing Agreement Program:
Employer L may also correct this error under Audit CAP (see example 3).

Example 3:
Employer M maintains a 401(k) plan with 7,500 participants. Plan provisions allow for hardship distributions to participants. During a review of its operations, Employer M determined that 10 hardship distributions made during the 2012 plan year didn't have proper documentation and it didn't base five distributions on any hardship, but were nothing more than in-service distributions. No written procedures were in place to review a participant's application for a hardship distribution.

Correction programs available:

Self-Correction Program
This mistake may not be eligible to correct under SCP since no adequate practices and procedures for hardship distributions were in place.

Voluntary Correction Program
Employer M may correct this mistake under VCP. M must request that the five participants who received distributions not meeting the plan hardship requirements repay the amounts plus earnings to the plan. In addition, M must improve its hardship administrative procedures. Expecting participants to repay these amounts may pose a problem because the participants may have already spent the funds. A plan document requiring spousal consent for distributions, plus possible tax issues on the distributions could further complicate the final correction. Correction will depend on the facts and circumstances of each situation and may include, in some form, paybacks, employer corrective contributions and plan amendments. If this represents your situation, file a VCP submission and work with the IRS agent to determine the proper correction. The fee for the VCP submission for a 7,500-person plan is $20,000.

Audit Closing Agreement Program:
Most plans are eligible for Audit CAP, which allows the plan sponsor to correct the mistake and pay a negotiated sanction. This sanction will bear a reasonable relationship to the nature, extent and severity of the mistake, considering many factors, including the extent to which correction occurred before audit. Sanctions under Audit CAP are a negotiated percentage of the maximum payment amount.

How to avoid the mistake:

  • Review the plan document language to determine when and under what circumstances you can make distributions.
  • When you amend your plan document, make certain the language for hardship distributions is in the most recent document.
  • Establish hardship distribution procedures working with your benefits professional to determine if these procedures are sufficient to avoid mistakes.
  • Only allow hardship distributions that meet the plan document and IRC Section 401(k) requirements.
  • Look for signs that the hardship distribution program is being abused or badly managed.
    • Too many hardship requests by one group or division may be a sign of abuse.
    • Requests for hardship distributions from multiple employees appear identical. Each situation should have its own individual circumstances.
    • Only the highly compensated employees have hardship distributions. This may be a sign that rank-and-file employees haven't been properly notified of the availability of hardship distributions.

401(k) Plan Fix-It Guide
401(k) Plan Overview
EPCRS Overview
401(k) Plan Fix-It Guide (pdf)
401(k) Plan Checklist
Additional Resources

IRS.gov / Retirement Plans / Correcting Plan Errors / Fix-It Guides / Potential Mistake

Page Last Reviewed or Updated: 21-Jul-2014