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Issue Snapshot - Hardship Distributions from 401(k) Plans

A 401(k) plan may permit distributions to be made on account of a hardship. With respect to the distribution of elective deferrals, a hardship is defined as an immediate and heavy financial need, and the distribution must be necessary to satisfy the financial need. If the plan permits, certain employer matching contributions and employer discretionary contributions may also be distributed on account of a hardship, although the standard for a distribution may be different. Qualified matching contributions (QMACs), qualified nonelective matching contributions (QNECs), and income earned on elective deferrals may not be distributed on account of a hardship.

This Snapshot examines the criteria required for hardship distributions. Different restrictions apply to hardship distributions made from elective deferrals that were contributed prior to 1989. A discussion of those rules is beyond the scope of this Snapshot.

IRC Section and Treasury Regulations

Resources

Analysis

Qualified retirement plans are subject to a variety of distribution restrictions. For example, a pension plan generally cannot distribute funds until normal or early retirement, absent death, disability or termination of employment. See Reg. § 1.401-1(b)(1)(i). Profit sharing plans can make distributions earlier than this time frame, but only on a stated event or a fixed number of years, such as after 5 years of participation. See Reg. § 1.401-1(b)(1)(ii), Rev. Rul. 71-224, 1971-1 C.B. 124, and Rev. Rul. 71-295, 1971-2 C.B. 184.  Most 401(k) plans are profit sharing plans and, therefore, generally may allow (but are not required to allow) distributions to participants of employer matching contributions (other than QMACs ) and employer discretionary contributions (other than QNECs ) on account of a financial hardship.

Elective deferrals under 401(k) plans are subject to more stringent distribution restrictions, but also may be distributed on hardship if special rules are satisfied. See IRC § 401(k)(2)(B).  QMACs, QNECs, and earnings on elective deferrals are not available for hardship distributions. As noted earlier, different rules applied for pre-1989 elective deferral contributions. A discussion of those rules is beyond the scope of this Snapshot.

Hardship definition – elective deferrals

A hardship distribution from a participant’s elective deferral account can only be made if the distribution is:

  • because of an immediate and heavy financial need,
     
  • limited to the amount necessary to satisfy that financial need, and
     
  • limited to the participant’s total elective deferrals as of the date of distribution, reduced by the amount of previous distributions of elective deferrals.

Determination of both the existence of an immediate and heavy financial need and of the amount necessary to meet this need must be made in accordance with nondiscriminatory and objective standards under the plan.

Determination of existence of need

Whether an employee has an immediate and heavy financial need depends on all relevant facts and circumstances. However, many plans include the “safe harbor” provisions in Reg. § 1.401(k)-1(d)(3)(iii)(B) to determine if the distribution is on account of a participant’s hardship. Pursuant to the “safe harbor” provisions, a distribution is deemed to be on account of an immediate and heavy financial need of the employee if the distribution is for:

  • Generally, expenses for medical care previously incurred by the employee, the employee’s spouse, or any dependents of the employee 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 up to the next 12 months of postsecondary education for the employee, or the employee’s spouse, children, or dependents;
     
  • Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence;
     
  • Burial or funeral expenses for the employee’s deceased parent, spouse, children, or dependents; or
     
  • Certain expenses relating to the repair of damage to the employee’s principal residence that would qualify for the casualty deduction under IRC § 165.

The plan may also permit distributions for medical care, tuition, and funeral expenses for certain beneficiaries of the participant.  See Notice 2007-7, 2007-1 C.B. 395.

Determination that amount is necessary

The hardship distribution must be limited to the amount necessary to satisfy the financial need.  The amount of an immediate and heavy financial need may include any amounts necessary to pay any federal, state, or local taxes or penalties reasonably anticipated to result from the distribution.

A distribution generally is not treated as necessary to satisfy an immediate and heavy financial need to the extent the need can be relieved from other resources that are reasonably available to the employee.  For this purpose, an employer may rely on the employee’s representation (unless the employer has actual knowledge to the contrary) that the need cannot reasonably be relieved –

  • Through reimbursement or compensation by insurance or otherwise,
     
  • By liquidation of the employee’s assets,
     
  • By stopping the elective contributions or employee contributions under the plan, or
     
  • Generally, by other distributions or nontaxable loans from plans maintained by the employer or by any other employer, or by borrowing from commercial sources.

A need is not reasonably relievable by one of the actions described in the above paragraph if the effect would be to increase the amount of the need.

A distribution is deemed necessary to satisfy an immediate and heavy financial need if –

  • The employee has generally obtained all available distributions and nontaxable loans from all plans maintained by the employer, and
     
  • The employee is prohibited, under the terms of the plan or an otherwise legally enforceable agreement, from making elective deferrals and employee contributions to the plan and all other plans maintained by the employer for at least 6 months after receipt of the hardship distribution.

Hardship distributions other than elective deferrals

The preceding discussion summarizes the criteria for hardship distributions of elective deferrals. Funds attributable to employer discretionary and matching contributions (other than QMACs and QNECs) may be distributed under more lenient hardship rules, provided that “hardship” is sufficiently defined, consistently applied, and the distribution does not exceed a participant’s vested interest. See Rev. Rul. 71-224. A plan does not have to use the criteria set forth in Reg. § 1.401(k)-1(d)(3), discussed above, for making hardship distributions of funds that are not attributable to elective deferrals, but as a practical matter most plans do in order to avoid having two administrative and review procedures.

Audit tips

  1. Review the plan document.
     
  2. Examine the hardship distribution form(s) and any written statements provided by the employee for proper signatures, especially spousal consent (if applicable).
     
  3. Make sure that the distribution is limited to the maximum distributable amount related to the source of the funds.
     
  4. Examine the records the employer used to establish whether a hardship exists and the amount of the hardship. Records containing the necessary information may include, but aren’t limited to, medical bills, tuition bills, eviction notices, or closing sheets for the purchase of a principal residence.
     
  5. For elective deferrals, examine the documentation provided by the employee to determine that the employee has no other reasonably available resource to relieve the hardship. This can be limited to an employee representation.
     
  6. For elective deferrals, verify that the employee obtained available distributions and loans and was prohibited from making contributions for 6 months after the hardship distribution.
     
  7. Examine the returned check(s).  
    • Check for names
    • Check for dates
  1. Examine the trust fund statement.
     
  2. Make sure the distribution is properly reported on Form 1099-R.
     
  3. Look for indicators of fraud.