Today, more and more participants are requesting hardship distributions from their 401(k) plans in an effort to make ends meet. While you no doubt want to comply with their requests, you don't want to do so to the detriment of your plan. It's critical to understand what the law allows and to review your plan's hardship distribution procedures in order to avoid the headaches that will result from impermissible hardship distributions.

Considering the limits, 1 2 3

The code allows hardship distributions from 401(k) plans to participants who are still actively employed by the plan sponsor, even if they are under age 59-1/2, subject to a number of limitations. Why is the proper review and handling of hardship distributions critical? If a plan makes an impermissible hardship distribution, the worst case headache is plan disqualification, with various pains preceding it.

The first limitation requires that the distribution be made on account of an immediate and heavy financial need of the participant. This determination is based on the facts and circumstances of each situation. The regulations provide that the need to pay the funeral expenses of a family member would constitute an immediate and heavy financial need, but the purchase of a boat or television would not "generally." Interestingly, a financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the participant.

The second limitation doesn't permit a distribution in excess of the amount necessary to satisfy the need that cannot be met by other resources reasonably available to the participant (including the assets of the participant's spouse and perhaps minor children). This amount may include federal, State or local taxes or penalties reasonably anticipated to result from the distribution. Unless the plan has actual knowledge to the contrary, the regulations allow a plan to rely on the participant's written representation that the need cannot reasonably be relieved by insurance, liquidation of other available assets, cessation of elective contributions, distributions, nontaxable loans available from employer plans or commercial loans.

The third limitation restricts the funds that are available for hardship distributions, namely, the participant's accumulated elective contributions, not including earnings thereon, reduced by losses and any prior distributions. Accumulated qualified employer nonelective contributions and qualified matching contributions aren't available for hardship distributions (unless the plan provides for the distribution of amounts credited to the participant's account as of a specified date not later than December 31, 1988 or the end of the last plan year ending before July 1, 1989). Note that employer contributions other than QNECs and QMACs may also be available for hardship distributions under rules that have applied to profit sharing plans since before 401(k) plans became so popular.

What does your plan allow?

The code and regulations plainly require that if a plan is to allow hardship distributions, the plan document must expressly provide for such distributions. Although the plan will have to grant discretion to the administrator to determine whether the claimed hardship qualifies for a distribution, that discretion must be guided by nondiscriminatory and objective standards set forth in the plan.

There's no guarantee that the plan's guidelines as to what is an immediate and heavy financial need will conform to the vague requirements of the code and regulations. Therefore, the regulations provide a safe harbor set of guidelines for what qualifies as an immediate and heavy financial need, and the plan may incorporate those guidelines in order to be safe. For example, expenses for medical care and expenses to prevent eviction from the participant's principal residence are within the safe harbor. 

Most plans do use the safe harbor guidelines for what qualifies as an immediate and heavy financial need. But plan administrators need to understand that the use of such safe harbors may require them to treat hardship differently than they would if the plan did not use the safe harbors. For example, if a participant requests a hardship distribution to prevent eviction, the plan administration may need to withhold a hardship distribution until an actual eviction or foreclosure proceeding has commenced – even though it may mean the participant missing a significant number of rent or mortgage payments.

Similarly, the plan must define what is "necessary" within the meaning of a distribution not exceeding what is necessary to satisfy the need. Here again, the regulations provide a safe harbor provision that may be incorporated in the plan document. A distribution may be deemed necessary if:

•The employee has taken all distributions and nontaxable loans that are available under the employer-sponsored plans in which the applicant participates.

•The employee is prohibited from making any elective contributions or after-tax employee contributions to any plan sponsored by the employer for at least six months (does not include mandatory employee contributions to a defined benefit pension plan nor employee contributions to a health or welfare benefit plan).

Does your plan use this safe harbor?

If your plan is like most 401(k) plans, it allows hardship distributions only upon satisfaction of the safe harbor rules. However, if you are regularly receiving requests for hardship distributions that cannot be granted under the safe harbor rules, it may be appropriate to consider the use of other standards that may be more helpful to your employees (but which also may require more careful substantiation).

What procedures are you following?

Once the plan document sufficiently provides for hardship distributions, the main traps for the unwary administrator are the failure to follow the terms of the plan and the failure to adequately document the decision to grant (or deny) the request for a distribution. Your documentation of each decision should include:

•The participant's application with the participant's written representations as to the hardship involved and whether other resources have been exhausted; and

•Your determinations regarding whether the participant has an immediate and heavy financial need, whether the need can be met by other resources reasonably available to the participant, whether the amount to be distributed is not in excess of the amount needed and the source of the distribution.

Sloppy documentation and inconsistent or overly liberal distributions may result down the road in the need for corrections under the IRS's Employee Plans Compliance Resolution System, in IRS audits, or even in plan disqualification.

What to do?

Now is an ideal time to review your plan's hardship provisions, modify them if appropriate, and make certain that you are following them in responding to any request for a hardship distribution. A little preventive maintenance now can avoid headaches down the road.

Kenneth W. Ruthenberg Jr., shareholder at Chang, Ruthenberg & Long PC, may be reached at (916) 357-5660 or kwr@seethebenefits.com.

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