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403(b) Plan Fix-It Guide - You don’t have documentation ensuring that hardship distributions meet the definitions and requirements for hardship distributions

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10) You don’t have documentation ensuring that hardship distributions meet the definitions and requirements for hardship distributions.

Review all in-service distributions and determine that hardship distributions met the plan requirements.

 

Amend your plan retroactively to allow for hardship distributions.

 

Be familiar with your plan hardship provisions. Implement procedures to ensure that you follow the provisions in operation. Ensure that the plan administrators and payroll offices share the plan’s hardship distribution information.

IRS rules treat a distribution as a hardship distribution only if it is made both:

  • because of an immediate and heavy financial need of the employee, and
  • is not more than an amount necessary to satisfy that financial need.

Additionally, the 403(b) written program must:

  • allow for hardship distributions, and
  • contain language that specifies how a hardship is determined.

Immediate and heavy financial need  
The plan sponsor or other persons responsible for administering the plan (but never the employee requesting the hardship) may determine eligibility for a hardship distribution. They must make the determination of an immediate and heavy financial need and the amount necessary to meet the need with objective standards in the written plan. A distribution made to an employee for the purchase of a boat or television would generally not constitute a distribution made because of an immediate and heavy financial need. A financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee.

IRS rules deem certain distributions are because of an employee’s immediate and heavy financial need if the distribution is for:

  • Expenses for medical care previously incurred by the employee, the employee’s spouse, any dependents of the employee or the employee’s beneficiary or 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, or the employee’s spouse, children or 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’s deceased parent, spouse, etc.; or
  • Certain expenses relating to the repair of damage to the employee’s principal residence.

Starting in 2009, the 403(b) written plan or program should be amended prior to making any hardship distributions based on these events.

Keep in mind that an immediate and heavy financial need is based on all relevant facts and circumstances and may include reasons other than those described above.

Amount necessary to satisfy the financial need
You can’t treat a distribution as necessary to satisfy an immediate and heavy financial need if:

  • The distribution is more than the amount needed to relieve the employee’s financial need,
    • The amount needed may include amounts to pay any federal, state or local income taxes or penalties reasonably anticipated to result from the distribution.

  • The need can otherwise be relieved by:
    • Reimbursement or compensation by insurance or otherwise;
    • Liquidation of the employee’s assets;
    • Cessation of elective or employee contributions under the plan;
    • Other distributions or nontaxable loans (at the time of the loan) from plans maintained by the employer or any other employer;
    • Borrowing from commercial sources on reasonable commercial terms in an amount sufficient to satisfy the need.

  • The financial need may be satisfied from other resources that are reasonably available to the employee including those assets of the employee’s spouse and minor children.
  • The distribution isn’t limited to the total of employee salary deferrals, excluding income, reduced by any prior hardship distributions.

One of the above actions can't reasonably relieve a financial need 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 financing.

The 403(b) plan sponsor must prohibit an employee, under the terms of the plan or an otherwise legally enforceable agreement, from making elective contributions and employee contributions to the plan and all other plans maintained by the employer for at least six months after receipt of the hardship distribution.

It’s important that a record be available of all information used to determine that a participant was eligible for a hardship distribution and the amount distributed was the amount necessary to alleviate the hardship. Failing to meet hardship requirements could cause the employee’s entire account to become immediately taxable. Even though the 403(b) plan sponsor may be relying on outside vendors for much of their plan administration, plan sponsors bear ultimate responsibility for following the written plan, including hardship requirements. Hardship distributions are generally subject to the 10% additional tax if they are made before the participant turns age 59 ½.

For distributions made after September 11, 2001, the 10% early withdrawal penalty does not apply to qualified reservist distributions. A qualified reservist distribution is:

  • One made to a reservist called to active duty for a period of at least 180 days or for an indefinite period.
  • Made beginning on the date of the order calling to active duty and ending on the close of the active duty period.
  • Made from an IRA or from amounts attributable to elective deferrals under a 403(b) plan, 401(k) plan or certain similar arrangements.

How to find the mistake:

Review your 403(b) plan to determine if it allows for hardship distributions, and then review your plan’s hardship procedures. If you don’t have procedures for reviewing hardship applications, establish them. If you discover the vendors have been solely responsible for the hardships, reach out to them and establish procedures for sharing hardship information and ensuring that employee contributions are suspended for at least six months.

Review all distributions made during the year and determine which ones may have been a hardship distribution. Distributions to participants who continue to be employees are very limited, so start your review with those distributions. For each hardship distribution, make a determination whether it met the hardship distribution requirements outlined by your 403(b) plan. If most of your hardship requests come from a specific group of employees, you may have some participants abusing the plan’s hardship feature.

How to fix the mistake:

Our discussion of mistakes involving hardship distributions focuses on mistakes involving plan document issues and distributions that don’t meet IRS hardship rules.

  • The 403(b) written program doesn't allow for hardship distributions, but in operation, hardship distributions do occur.
    • Correction may involve a retroactive amendment to allow hardship distributions.
    • Hardship distributions must have been made available, with the exception of public school employees, in a nondiscriminatory manner.

  • Hardship distributions are made to participants that don’t meet the hardship requirements of the written program or the 401(k) regulations.
    • Correction may involve a repayment to the plan of the amounts that didn’t meet the hardship requirements of the plan or the law.

Example 1:
ABC School maintains a 403(b) plan with 150 participants as of December 31, 2013. Plan provisions don’t allow for hardship distributions; however, hardship distributions were made to several participants during the 2008 and 2009 plan years. During a review of its plan operations, ABC determined that these hardship distributions were made available to all participants and the IRS rules for hardship distributions were met. ABC discovered the failure on July 1, 2013.

Example 2:
XYZ Public School, with 7,500 participants (as of December 31, 2013), provides for hardship distributions in its 403(b) plan; however, the 403(b) vendors make the determination that a distribution meets the hardship requirements and keep all the records. During an internal review of its plan for the 2011 year, XYZ determined that ten hardship distributions made by one vendor did not have documentation. Further investigation revealed that five of the distributions were not based on any hardship. There were no written procedures in place to review a participant’s hardship application. XYZ discovered the failure on April 27, 2012.

Correction programs available:

Self-Correction Program:

Example 1:
IRS considers this mistake an operational error that ABC may correct under SCP if ABC determines that:

  • it has established practices and procedures in place to promote the overall compliance of its plan, and
  • the hardship withdrawals were administered in a nondiscriminatory manner.

If ABC applies the provisions of Revenue Procedure 2013-12, they may correct the mistake by adopting a retroactive plan amendment, effective January 1, 2009, which would allow the 403(b) plan to provide for the hardship distributions that were made during 2009. This amendment must provide that the hardship distribution option is available in a nondiscriminatory manner. Note that the retroactive plan amendment can't be made effective prior to January 1, 2009, because there was no written plan requirement. This retroactive amendment correction method isn't available under Revenue Procedure 2008-50. For 2008, ABC wouldn’t have to take any action based on the facts in this example if the specific annuity contracts and/or custodial accounts of the affected plan participant contained appropriate financial hardship language. If this language wasn't in those documents or wasn't in compliance with the financial hardship rules, then it may be necessary to seek repayment of the hardship distributions by the affected participants if the participants are still employed by the plan sponsor.

Example 2:
This mistake may not be eligible to correct under SCP since neither XYZ, nor one of its 403(b) vendors maintained adequate policies and procedures in place for hardship distributions and overall compliance with the distribution restrictions applicable to 403(b) plans.

Voluntary Correction Program:  
ABC may also correct the mistake under VCP by adopting a retroactive plan amendment, effective January 1, 2009, to provide for the hardship distributions that were made available. The amendment must also provide that the hardship distribution option is made available in a nondiscriminatory manner. For 2008, ABC could apply the methods used for SCP in a VCP submission as long as the correction doesn’t involve corrective plan amendments.  

The fee for a 150-participant plan is $5,000. ABC should consider using the model documents in Appendix C, including Schedule 9 and Forms 8950 and 8951.

XYZ may correct this mistake under VCP.

  • For the five participants eligible to receive a financial hardship distribution, the plan sponsor will work with its 403(b) vendors to ensure that it obtains all necessary documentation before any financial hardship distributions are made. Those specific steps must be described and be part of the VCP submission.
  • XYZ must request that the five participants who received distributions that didn't meet the plan financial hardship requirements repay the amounts plus earnings to the plan.
  • In addition, XYZ must improve the plan administrative procedures regarding hardships to ensure that these distributions are only made if there's a genuine financial hardship consistent with the requirements of the regulations, and starting in 2009, the written terms of the 403(b) plan.

Expecting these amounts to be repaid in full to the plan may be a problem because the participants may have already spent the funds. Possible tax issues on the distributions could further complicate the final correction. Correction will depend on all the facts and circumstances of each individual situation and may include repayments and possibly some form of plan amendment. If this represents your situation, file a VCP submission and work with the agent to determine the proper correction.

The fee for a 7,500-participant plan is $20,000. XYZ would complete a submission according to Revenue Procedure 2013-12 to correct the mistake. XYZ should consider using the model document in Appendix C Part 1 and include Forms 8950 and 8951.

Audit Closing Agreement Program:
Under Audit CAP, correction of these mistakes is the same as described above. The plan sponsor and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount.

How to avoid the mistake:

Examples of what employers can do to cut down on mistakes in this area include:

  • Starting in 2009, review your 403(b) plan to determine when and under what circumstances a distribution can be made.
  • Make certain the written program matches your intentions for providing for hardship distributions.
  • Establish hardship distribution procedures with your 403(b) vendors. Work with your vendors and other service providers to determine if the procedures are sufficient to avoid mistakes.
  • Only allow hardship distributions that meet the requirements of the regulations and your 403(b) plan.
  • 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 that appear identical from multiple employees may require further attention.
    • Only the higher paid employees have hardship distributions. This may be a sign that rank-and-file employees have not been properly notified of the availability of hardships

403(b) Plan Fix-It Guide
EPCRS Overview
403(b) Plan Fix-It Guide (.pdf)
403(b) Plan Checklist (.pdf)
Additional Resources

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

Page Last Reviewed or Updated: 05-Jun-2014