Sometimes, plan sponsors don’t follow the terms of their plan document when it comes to hardship distributions. Some of the most common errors are:
- making hardship distributions even though they aren’t permitted by the plan document,
- allowing these distributions for reasons other than those stated in the plan document, and
- failing to suspend participant salary deferrals following a hardship distribution if required by plan terms.
To preserve the tax qualified status of the plan, the sponsor should correct these errors right away.
1. Plan document doesn’t permit hardship distributions
If a plan makes a hardship distribution, the plan document must contain the appropriate language to allow it. Plan sponsors may correct the operational failure of making hardship distributions to employees under a plan that doesn’t have hardship distribution language using the plan amendment correction method.
2. Hardship distribution for a reason not allowed by the plan
If the plan language allows hardship distributions only under specific circumstances, the plan can’t be more liberal in its operation. For example, if the plan states hardships distributions can only be made to pay tuition, then the plan can’t permit a hardship distribution for any other reason, such as a home purchase. And, while the law permits hardships for funeral expenses, a plan can’t distribute funds unless it specifically lists these expenses as a stated reason for a hardship. Again, if a plan sponsor decides to be more liberal in its definition of a hardship, then the plan sponsor must prospectively amend their plan.
3. Failing to suspend participant salary deferrals
If your plan terms require an employee to be suspended from contributing to the plan making the distribution and all other employer plans for at least six months after receiving a hardship distribution, then your plan must suspend salary deferrals. If your plan fails to do this, here are some correction options:
- Option 1 - Suspend the employee from making salary deferrals for a six month period going forward. However, this may not put the participant in the same position as they would’ve been if you suspended their contributions immediately after receiving the hardship distribution. For example, the plan’s matching contribution levels for the six month period going forward could be different than what they were during the correct suspension period.
- Option 2- Return the hardship distribution. The employee could return the hardship distribution (adjusted for earnings) to the plan. This could put the employee in the same position she would’ve been in had the failure not occurred. This approach may not be a viable solution because the affected employee may not have the resources to repay a hardship distribution. Note, the plan sponsor can’t address a failure to suspend salary deferrals by simply revising administrative procedures going forward because this option wouldn't correct the failure to suspend elective deferrals of salary in the past.
The Bipartisan Budget Act of 2018 made changes to the 401(k) hardship rules. Effective in 2019, plan sponsors have the option to no longer suspend salary deferrals due to a plan participant’s receipt of a hardship distribution. Beginning in 2020, the suspension requirement is prohibited. On November 14, 2018, the IRS issued proposed regulations relating to changes in the 401(k) hardship distribution rules
The above correction methods still apply for plan years prior to 2019(or 2020) as the change in tax law does not exempt plan sponsors from correcting the failure to suspend elective deferrals in the event of a participant’s receipt of a hardship plan.