Hardship Distributions: T’s to Cross and I’s to Dot (article)
A qualified retirement plan, such as an IRC Section 401(k) plan or 403(b) plan, can include a hardship withdrawal provision. If a plan is to include a hardship withdrawal provision, it is subject to many restrictions.
In summary, a hardship withdrawal is available to a plan participant in the event he/she experiences an immediate and heavy financial need. The current IRS and Treasury regulations set forth the criteria for determining whether an expense constitutes an immediate and heavy financial need. For example, while paying the funeral expenses of a family member would probably meet this criteria, the purchase of a boat or a TV would not. According to these safe harbor rules, a distribution from a qualified plan is deemed to be an immediate and heavy financial need if the distribution is for:
- Necessary medical care expenses that would be deductible under IRC Section 213(d), determined without regard to whether the expenses exceed 10 percent of adjusted gross income;
- 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 12 months of post-secondary education for the employee, spouse, children, or qualified tax dependents;
- Payments necessary to prevent the eviction of the employee from his/her principal residence or foreclosure on the mortgage on that residence;
- Payments for burial or funeral expenses for the employee's deceased parent, spouse, children or qualified tax dependents; or
- Expenses for the repair of damage to the employee’s principal residence that would qualify for the casualty deduction under IRC Section 165.
Generally, a hardship distribution is treated to satisfy an immediate and heavy financial need only to the extent the amount of the distribution does not exceed the amount required to satisfy the financial need, with an option to include any amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution.
In addition, substantiation of the immediate and financial need is required. Recently, the IRS released two nearly identical Memoranda, one specific to 401(k) plans and the other specific to 403(b) plans; both of these are directed at internal IRS auditors who audit plans. The Memoranda sets forth modified substantiation guidelines to assist in determining whether a hardship distribution is deemed to meet the immediate and heavy financial need criteria. While this type of IRS directive does not carry the force of law, it does give plan administrators an idea on what is important to the IRS.
According to this Memoranda, there are two steps involved for making the financial burden determination:
The first step is to determine whether the employer or third-party administrator (TPA), prior to making a distribution, either:
- Obtains source documents from the employee-participant such as estimates, contracts, bills and statements from third parties; or
- Obtains only a summary of information contained in such source documents. In this instance, the employer or TPA should then notify the employee-participant requesting the distribution stating that:
- The hardship distribution is taxable and additional taxes could apply;
- The amount of the distribution cannot exceed the immediate and heavy financial need;
- Hardship distributions cannot be made from earnings on elective contributions or from qualified non-elective contribution (QNEC) or qualified matching contribution (QMAC) accounts, if applicable; and
- The employee-participant agrees to preserve the actual source documents of the expenses and make them available at any time, upon request, to the employer or TPA. This could be problematic in that at the time of an IRS audit, the individual may have terminated employment, or may have otherwise failed to retain the source documents. Thus, many plan administrators may wish to receive the actual substantiation documentation.
In the second step, the employer or TPA must review the information received from the employee-participant to determine whether it substantiates the hardship distribution requirements. The page labeled “Attachment 1” contained in the Memoranda provides a sampling of questions that an employer or TPA could use when seeking substantiation for a specific purpose. For example, if the request for the hardship withdrawal is to pay medical care expenses, then the employee-participant should provide documentation that:
- Identifies the individual who incurred the medical expenses and the relationship to the employee-participant (self, spouse, dependent, or primary beneficiary under the plan);
- Describes the purpose of the medical care; for example, diagnosis, treatment, prevention, associated transportation, long-term care;
- Provides the name and address of the service provider(s) such as the hospital, doctor, dentist, chiropractor, pharmacy; and
- Identifies the amount of medical expenses not covered by insurance.
It should be noted that if a plan permits more than two hardship distributions a year, additional substantiation could be required. Plans may want to limit hardship distributions to no more than two withdrawals per year.
For additional information relating to hardship distributions, the IRS provides some FAQs and tips for retirement plan sponsors:
The information contained in this article is provided as general guidance and may be affected by changes in law or regulation. This article is not intended to replace or substitute for accounting or other professional advice. Please consult a CBIZ professional. This information is provided as-is with no warranties of any kind. CBIZ shall not be liable for any damages whatsoever in connection with its use and assumes no obligation to inform the reader of any changes in laws or other factors that could affect the information contained herein.