Issue Snapshot - Hardship Distributions from 401(k) Plans

 

A 401(k) plan may permit the distribution of certain contributions (and attributable earnings) on account of an employee's hardship, but only if made in accordance with rules contained in the regulations under IRC Section 401(k). Under these rules, a distribution is made on account of an employee's hardship only if the distribution both is made on account of an immediate and heavy financial need of the employee and is necessary to satisfy the financial need. The determination of the existence of an immediate and heavy financial need and of the amount necessary to meet the need must be made in accordance with nondiscriminatory and objective standards set forth in the plan. See Reg. Section 1.401(k)-1(d)(3).

Under Reg. Section 1.401(k)-1(d)(3), the following may be distributed upon hardship of the employee:

  • Contributions to a profit-sharing or stock bonus plan to which IRC Section 402(e)(3) applies (that is, elective deferrals made to one of these plans).
  • Qualified nonelective contributions (as defined in IRC Section 401(m)(4)(C)).
  • Qualified matching contributions (as defined in IRC Section 401(k)(3)(D)(ii)(I)).
  • Earnings on any contributions listed above.

    See IRC Section 401(k)(14)(A).

A distribution shall not be treated as failing to be made due to an employee's hardship solely because the employee does not take any available loan under the plan. See IRC Section 401(k)(14)(B).

This Snapshot examines the criteria for current hardship distributions. Different restrictions applied to hardship distributions made before 2020 (the mandatory effective date of the new rules under Reg. Section 1.401(k)-1(d)(3)), although employers could apply all or some of the new rules earlier). For example, hardship distributions of amounts described in the second through fourth bullets above generally were not permitted, and in many cases, an employee's elective deferrals had to be suspended for a period following a distribution. 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 make in-service distributions unless the plan terminates, or the employee has attained age 59½. See Reg. Section 1.401-1(b)(1)(i) and IRC Section 401(a)(20) and (36). Profit-sharing plans can make in-service distributions in more situations; for example, upon the occurrence of a stated event (including an employee's hardship) or after a fixed number of years. See Reg. Section 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.

A qualified cash or deferred arrangement (CODA) is any arrangement which is part of a profit-sharing, stock bonus, pre-ERISA money purchase, or a rural cooperative plan under which an eligible employee may elect to have the employer make payments as contributions to a trust under the plan on behalf of the employee, or to the employee directly in cash. See IRC Section 401(k)(2). These contributions are usually referred to as "elective deferrals" and a plan containing a CODA as a "401(k) plan." (Nearly all 401(k) plans are profit-sharing plans.)

IRC Section 401(k)(2)(B) specifies the situations under which distributions of amounts in a qualified CODA are permitted. For example, IRC Section 401(k)(2)(B)(i)(IV) and (14)(A) provides that elective deferrals made under a qualified CODA that is part of a profit-sharing or stock bonus plan (and attributable earnings) may be distributed upon hardship of the employee. IRC Section 401(k)(14)(A) provides that qualified matching contributions (QMACs), qualified nonelective contributions (QNECs), and earnings on these contributions may also be distributed upon hardship of the employee.

QNECs are contributions, other than elective deferrals and matching contributions, made by the employer (whether or not the employee makes elective deferrals or after-tax employee contributions) that are subject to the same distribution restrictions as apply to elective deferrals, are 100% nonforfeitable when allocated, and are subject to the nondiscrimination requirements under IRC Section 401(a)(4). See Reg. Section 1.401(k)-6.

QMACs are matching contributions that, like QNECs, are subject to the same distribution restrictions as apply to elective deferrals and are 100% nonforfeitable when allocated. A matching contribution is an employer contribution made on account of an employee's after-tax employee contribution or on account of an elective deferral. See Reg. Section 1.401(k)-6.

Hardship definition

Under the regulations, a hardship distribution can only be made if the distribution is because of an employee's immediate and heavy financial need and is limited to the amount necessary to satisfy that financial need.

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 set forth in the plan.

See Reg. Section 1.401(k)-1(d)(3)(i).

Determination of existence of need

Whether an employee has an immediate and heavy financial need depends on all relevant facts and circumstances. A financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee. See Reg. Section 1.401(k)-1(d)(3)(ii)(A).

A distribution is deemed to be on account of an immediate and heavy financial need of the employee if the distribution is for:

  • Expenses for (or necessary to obtain) medical care for the employee, the employee's spouse, the employee's dependents, or a primary beneficiary under the plan;
  • 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 post-secondary education for the employee, the employee's spouse, the employee's dependents, or a primary beneficiary under the plan;
  • 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, dependents or primary beneficiary under the plan;
  • Certain expenses relating to the repair of damage to the employee's principal residence that would qualify for the casualty deduction under IRC Section 165 (determined without regard to IRC Section 165(h)(5); or
  • Expenses and losses incurred by the employee as a result of a disaster declared by the Federal Emergency Management Agency (FEMA), provided that the employee's principal residence or principal place of employment at the time of the disaster was located in an area designated by FEMA for individual assistance with respect to the disaster.

See Reg. Section 1.401(k)-1(d)(3)(ii)(B).

A primary beneficiary under the plan is an individual who is named as a beneficiary under the plan and has an unconditional right, upon the death of the employee, to all or a portion of the employee's account balance under the plan. See Reg. Section 1.401(k)-1(d)(3)(ii)(C).

Determination that amount is necessary

The hardship distribution must be limited to the amount necessary to satisfy the immediate and heavy 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. See Reg. Section 1.401(k)-1(d)(3)(iii)(A).

A distribution is not treated as necessary to satisfy an immediate and heavy financial need of an employee unless:

  • The employee has obtained all other currently available distributions (including distributions of ESOP dividends under IRC Section 404(k), but not hardship distributions) under the plan and all other plans of deferred compensation, whether qualified or nonqualified, maintained by the employer;
  • The employee has provided to the plan administrator a representation in writing (including by using an electronic medium as defined in Reg. Section 1.401(a)-21(e)(3)), or in such other form as may be prescribed by the Commissioner, that he or she has insufficient cash or other liquid assets reasonably available to satisfy the need; and
  • The plan administrator does not have actual knowledge that is contrary to the representation.

See Reg. Section 1.401(k)-1(d)(3)(iii)(B).

Alternative distribution rules and hardship criteria

Funds in a 401(k) plan that is a profit-sharing plan, which are attributable to employer contributions other than elective deferrals, QMACs, and QNECs, may be distributed under more lenient hardship rules, provided that "hardship" is sufficiently defined in the plan, it is 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. Section 1.401(k)-1(d)(3), discussed above, for making hardship distributions of these funds, 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 amount necessary to satisfy the financial need.
  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. Examine the documentation provided by the employee to determine that the employee has insufficient cash or other liquid assets reasonably available to relieve the hardship. This must be represented in writing by the employee.
  6. Examine the records to determine that the employee has obtained all other available distributions from the plan.
  7. Examine the trust fund statement.
  8. Make sure the distribution is properly reported on Form 1099-R.
  9. Look for indicators of fraud.