401(k) plans must, by law, limit the circumstances under which plan money can be withdrawn by active employees. However, 401(k) plans can (and most do) allow in-service withdrawals in the event of an employee’s financial hardship. The COVID-19 pandemic is guaranteed to have financial repercussions for many 401(k) participants, and hardship distributions may provide a financial bridge to better times. The post summarizes the hardship distribution rules to help 401(k) plan sponsors prepare for an uptick in requests. It should be noted that the hardship distribution rules changed in 2018 and 2019, so employers are advised to confirm that they are familiar with the most current rules.
Hardship Distribution Requirements
Plan Allows the Hardship Distribution
First and foremost, a 401(k) plan must actually permit the hardship distributions (most do, but not all).
Immediate and Heavy Financial Need Exists
Under a plan that allows hardship distributions, an employee may take a hardship distribution if they have an immediate and heavy financial need, determined based on all of the relevant facts and circumstances. A financial need may be immediate and heavy even if it was reasonably foreseeable and voluntarily incurred.
The IRS has deemed a distribution to be on account of an “immediate and heavy financial need if the distribution is for:
- Expenses for (or necessary to obtain) medical care that would be deductible under Code Section 213(d), determined without regard to the limitations in Code Section 213(a) (relating to the applicable percentage of adjusted gross income and the recipients of the medical care) provided that, if the recipient of the medical care is not listed in Code Section 213(a), the recipient is 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, for the employee's spouse, child or dependent (as defined in Code Section 152 without regard to Code Section 152(b)(1), (b)(2) and (d)(1)(B)), or for 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;
- Payments for burial or funeral expenses for the employee's deceased parent, spouse, child or dependent (as defined in Code Section 152 without regard to Code Section 152(d)(1)(B)), or for a deceased primary beneficiary under the plan;
- Expenses for the repair of damage to the employee's principal residence that would qualify for the casualty deduction under Code Section 165 (determined without regard to Code Section 165(h)(5) and whether the loss exceeds 10% of adjusted gross income); or
- Expenses and losses (including loss of income) incurred by the employee on account of a disaster declared by the Federal Emergency Management Agency (FEMA) under the Robert T. Stafford Disaster Relief and Emergency Assistance Act, Public Law 100-707, 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.
The IRS may expand this list through guidance of general applicability.
Distribution is Necessary to Satisfy Immediate and Heavy Financial Need
The amount of the distribution may not exceed the amount needed to relieve the financial need (including reasonably anticipated federal, state or local taxes). A distribution will not be considered necessary to satisfy the immediate and heavy financial need unless:
- The employee has obtained all other available distributions under the plan and the employer's other qualified and non-qualified plans (excluding other hardship distributions),
- The employee represents to the plan administrator in writing (including by an electronic medium) that the employee has insufficient cash or other liquid assets reasonably available to satisfy the financial need, and
- The plan administrator does not have actual knowledge that is contrary to the employee's representation.
Plans have the discretion to impose additional conditions for an “immediate and heavy financial need”, but may no longer provide for a suspension of employee contributions (see below). Of note: under prior regulations, employees were required to first obtain all available loans from a plan before a hardship distribution would be available. Plans are no longer required to impose this condition, but may continue to do so in their discretion.
Sources of Funds for Withdrawal
Plans may allow hardship distributions to be funded from employee contributions, employer qualified nonelective contributions (QNECs), qualified matching contributions (QMACs) and earnings on any of the above. However, a plan that permits hardship distributions is not required to allow hardship distributions from all of these sources.
6-Month Suspension Rule Has Been Eliminated
A plan may not provide for a suspension of an employee’s contributions to any plan described in Code Section 401(a), 403(a), 403(b), or 1.457-2(f) as a condition of obtaining a hardship distribution. Prior to 1/1/20, plans were required to impose a 6-month suspension on employee contributions following a hardship distribution, but this requirement has been eliminated.
Action Steps for Employers
Hardship distributions are permitted in abroad variety of circumstances which may become relevant to many employees in the coming days, weeks and months. Employers who sponsor 401(k) plans are encouraged to review their plan documents and the hardship rules and be prepared to process increased hardship distribution requests. Employers who rely on third party administrators to process hardship distributions should confirm that these services are in place. Employers with plans that do not currently permit hardship withdrawals may want to consider adding this feature.
However, employers are also cautioned to avoid encouraging hardship distributions. Absent any government relief, the distributions will be subject to a 10% early withdrawal penalty as well as income taxes, and are irrevocable. The distributions will also reallocate important retirement dollars. Employees should be encouraged to consult with their own advisors to determine whether a hardship distribution makes sense for them.