Navigating the Shoals of 401(k) Hardship Withdrawals

Permitting hardship withdrawals is a mixed bag. On the plus side, some employees might not agree to join the plan if they lack the freedom to tap their accounts in a crisis. On the negative side, allowing withdrawals may cause some employees to look upon the plan as more of a short-term savings vehicle. Also, handling hardship withdrawal processing can chew up administrative resources and provide more opportunities to incur the wrath of the IRS.

And, employees who jump through the necessary hoops to receive a hardship withdrawal will pay a big price -- the same as they would with a garden variety premature withdrawal: Taxation on the withdrawal, plus a 10% tax penalty (for employees under the age of 59 1/2).

That penalty is waived, however, if the employee:

• Is completely disabled,

• Has medical bills exceeding 7.5% of income,

• Needs the funds to prevent being evicted or foreclosed upon for a primary residence, and

• Is leaving your employ.

Permitted Withdrawal Circumstances

Hardship withdrawals are allowable under the following circumstances -- but you as the plan sponsor can choose which ones you will deem worthy of a hardship withdrawal (including none). These withdrawals can help to pay for:

• A primary home,

• Education tuition, room and board, and fees for the next 12 months for the employee, the employee's spouse or other dependents,

• Unreimbursed medical expenses,

• Funeral expenses for immediate family members, and

• "Severe financial hardship."

Employees must exhaust other resources, generally including plan loans, if you allow them, before requesting a hardship withdrawal. The IRS allows employees to take hardship withdrawals without seeking a plan loan under two scenarios:

1. Interest on the loan would put the employee in an even more desperate situation, or
2. the new debt would disqualify the employee from taking out a mortgage on a principal residence.

Verifying Eligibility

Keep in mind that if you allow hardship withdrawals to be taken which do not satisfy IRS requirements, you risk disqualifying your plan. Disqualification comes with potentially huge adverse tax consequences for you and your employees. That puts a burden on you, to some extent, to verify an employee seeking a hardship withdrawal is indeed facing the circumstances which make him or her eligible for the distribution.

While you can rely on an employee's written statement attesting to the truth of the hardship circumstance, the IRS also expects you to look for any documentation which would back up those claims. For example, if an employee seeks a hardship withdrawal to finance college expenses, request a copy of the invoice.

Sometimes you may need to split hairs and rely closely on the fine print of IRS definitions. For example, suppose an employee wants to use a hardship withdrawal to pay for the cost of having an unsightly (but noncancerous) mole removed from his face. Would this be allowable?

The answer depends on the definition of "medical care." As defined in Internal Revenue Code Section 213(d)(1), medical care refers to sums paid for:

• The diagnosis, cure, mitigation, treatment, or prevention of disease, for the purpose of affecting any structure or function of the body,

• Transportation to receive services described above,

• Qualified long-term care services, and

• Insurance (including amounts paid as premiums under … the Social Security Act) relating to supplementary medical insurance for the aged.

The amount of the permitted withdrawal can be enough not only to cover the immediate need, but taxes and penalties associated with taking the withdrawal.

Typical Trouble Spots

What kind of trouble do employers typically run into administering hardship withdrawals? The IRS has issued a list of the leading offenses. At the top of the list is allowing hardship withdrawals for purposes not specifically permitted in the plan's governing document. Implication: Read the list before agreeing to a hardship withdrawal.

Here are some more areas where employers find themselves in trouble during an audit:

• Unclear definitions of "hardship" or procedures for taking a qualified withdrawal,

• Failure to specify the category of 401(k) account funds eligible for withdrawal. For example, ever since 1988, only employee deferral amounts have been eligible for hardship withdrawals, but not investment earnings on those deferrals,

• Lack of an explanation that funds in employees' 401(k) accounts which got there via rollovers and transfers from other accounts are eligible for hardship withdrawals, and

• Failure to maintain adequate records documenting plan participants' eligibility for the hardship withdrawals they have taken.

Remember, you do not have to allow hardship withdrawals. But if you do, be prepared to commit the administrative resources required to handle them correctly.