Allowing employees access to their accounts in the event of hardship is an effective means to encourage participation in a 401(k) plan by employees who may otherwise be reluctant to defer salary. What do you need to know to develop and administer an effective hardship program?
Plan authorization of hardship distribution.
Hardship distributions from a 401(k) plan may not be made at the discretion of the employer, but must be authorized by the plan and made in accordance with plan terms. Specifically, the plan must set forth nondiscriminatory and objective standards for determining whether an employee has incurred an immediate and heavy financial need and the amount of the distribution required to satisfy that need.
Immediate and heavy financial need.
Immediate and heavy financial need is determined on the basis of all the relevant facts and circumstances. Financial need may enable an employee to qualify for a hardship distribution even if it was reasonably foreseeable and voluntarily incurred by the employee. For example, an employee may be allowed to take a distribution in order to pay the funeral expenses of a family member.
The IRS has provided safe harbors under which a distribution will be made on account of an immediate and heavy financial need if it is made in order to pay for:
- medical expenses not covered by medical insurance
- costs directly related to the employee's purchase of a principal residence (not including mortgage payments)
- tuition and related educational fees and room and board expenses for 12 months of post-secondary education
In addition, the safe harbor covers payments necessary to prevent the eviction of the employee from his or her principal residence or to avoid foreclosure on the mortgage on that residence.
Document occurrence of safe harbor event.
Although an employer is not required to verify that one of the safe harbor events has actually occurred, it may be wise to do so. Due to the nature of these events, documentation should be available.
Distribution necessary to satisfy financial need.
A hardship distribution is not treated as necessary to satisfy an immediate and heavy financial need if:
- It exceeds the amount required to relieve the need.
- The need may be satisfied by other resources that are reasonably available to the employee, such as a employee loan, or the assets of the employee's spouse and minor children.
Employer reliance on employee representation of need.
A distribution generally may be treated as necessary to satisfy a financial need if the employer (absent actual knowledge otherwise) relies upon the employee's written representation that the need cannot reasonably be relieved through:
- reimbursement or compensation by insurance or otherwise
- reasonable liquidation of the employee's assets
- other distributions or nontaxable (at the time of the loan) loans from the plans of the employer or any other employer, or loans from commercial sources at reasonable commercial terms
- ceasing elective contributions or after-tax employee contributions under the plan
Distribution necessary to satisfy financial need: Safe harbor.
A plan may deem a distribution to be necessary to satisfy a financial need if:
- the distribution is not in excess of the amount of the immediate and heavy financial need of the employee (including federal, state, or local income taxes or penalties reasonably expected to result from the distribution);
- the employee has obtained all distributions, other than hardship distributions, and all nontaxable (at the time of the loan) loans available under all plans maintained by the employer;
- the plan and all other plans maintained by the employer limit the employee's elective contributions for the next tax year to the deferral limit for that year, minus the employee's elective contribution for the year of the hardship distribution; and
- the plan, or an otherwise legally enforceable agreement, prohibits an employee from making elective contributions (and after-tax employee contributions) to the plan and all other plans maintained by the employer (excluding health and welfare plans) for at least 12 months after receipt of the hardship distribution.
A hardship distribution must be limited to an amount equal to the employee's total elective contributions as of the date of the distribution, minus the amount of any prior hardship distribution.
Amendment of plan hardship provisions.
An employer may amend a 401(k) plan to eliminate hardship distributions without violating the "anti-cutback" rules that generally prohibit plan amendments that reduce benefits. A plan may also be amended to specify or modify nondiscriminatory and objective standards for determining the existence of an immediate and heavy financial need, the amount necessary to meet the need, or other conditions relating to a employee's eligibility for a hardship distribution. Thus, a plan may be amended to specify or modify the resources an employee must exhaust in order to qualify for a hardship distribution or to require employees to provide additional statements or representations to establish a hardship.
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The information contained in this article is intended to provide useful information on the topic covered, but should not be construed as legal advice or a legal opinion.