Exam agents receive find many errors in the way retirement plan administrators apply the hardship distribution rules. Here are some tips on how to avoid the most common errors.
What are the most common hardship distribution errors found during plan audits?
Often, the exam agent finds that the plan made hardship distributions to participants even though the plan document didn’t permit these distributions.
We also find plans that allow hardship distributions but don’t follow the plan document’s specific hardship criteria and distribute the money for another reason. For example, if the plan states hardships distributions can only be made to pay tuition, then it can’t permit a hardship distribution for any other reason, such as a home purchase.
Read the plan document to ensure that it allows hardship distributions. If the plan doesn’t allow them, then the plan must be amended. Fortunately, a retroactive amendment is permitted under the Self-Correction Program if a plan made hardship distributions but didn’t have provisions authorizing them. Review the terms of the plan, including:
- whether the plan allows hardship distributions;
- the procedures the employee must follow to request a hardship distribution;
- the plan’s definition of a hardship; and
- any limits on the amount and type of funds that can be distributed for a hardship from an employee’s accounts.
If plan language allows hardship distributions only under specific circumstances, the plan can’t be more liberal in its operation. While the law permits hardships for funeral expenses, a plan can’t distribute funds for these expenses unless the plan has payment of funeral expenses as a stated hardship. Again, if a plan sponsor decides to be more liberal in its definition of a hardship, they must amend their plan.
Keep records of information that you used to determine a participant’s eligibility for a hardship distribution.
Keep in mind, the hardship distribution should only be made because of a participant’s (employee, employee's spouse, dependent or the employee's beneficiary) immediate and heavy financial need and should only be made in an amount necessary to satisfy that need. A distribution won’t be considered necessary to satisfy an immediate and heavy financial need if:
- it exceeds the amount needed to relieve the person’s financial need, or
- the participant can obtain money from other reasonably available resources.
If a plan allows loans, what are the required steps before granting a hardship distribution?
If the plan allows loans, it may require you to document that the employee has exhausted any loans or distributions, other than hardship distributions, available under the plan or any other plan of the employer in which the employee participates.
Tip: The plan sponsor should have procedures in place to review hardship applications and loans.
What do agents look for when they examine hardship distributions?
Agents examine hardship distributions to confirm they comply with the plan language and the law.
- Good internal controls will reduce or eliminate hardship distribution errors. When a plan has a strong internal control system, agents will usually check a sample of hardship distributions and move on to another area if they don’t find errors. Good internal controls lead to a smoother and more efficient overall examination.
- Recordkeeping – The plan sponsor, and not the plan participant, is responsible for verifying hardship requests and making hardship distributions only if they satisfy the plan rules and the law. For example, the agent will look for documentation that the:
- plan sponsor confirmed that the employee requesting the hardship had exhausted other permitted plan distributions, such as loans.
- hardship distribution didn’t exceed the amount necessary to satisfy the participant’s immediate and heavy financial need.
- Electronic hardship application – There's a growing trend for plans to grant hardships to participants who electronically apply for them. Participants use their PIN and self-certify that they meet the hardship criteria. While this seems to be an easy process for the participant, enabling them to quickly receive their distribution, this process doesn’t relieve the plan sponsor’s need for verification and recordkeeping. The agent will still look for the same documentation mentioned above to ensure that the plan made hardship distributions according to its terms and the law.
If the plan elects to use the ‘Summary substantiation method’ for the safe-harbor hardship distribution categories, the agent will first request the notices given to the participant and the form(s) describing the specific hardship request. For 401(k) plans, see Internal Revenue Manual (IRM) Section 18.104.22.168.4.1 (09-05-2017), and Exhibit 4.72.2-2, Attachment One Hardship Substantiation Information and Notifications for Summary of Source Documents. For 403(b) plans, see IRM Section 22.214.171.124.4.1.1 (08-11-2017)
We commonly see hardship distribution errors. However, a plan sponsor may reduce or even eliminate these errors by reading the plan, maintaining strong internal controls and having the proper documentation.