To ease employees’ concerns about access to their elective deferrals in the event of a financial emergency, an employer may provide for hardship withdrawals in its plan. This can provide some peace of mind during difficult times.

On the other hand, a hardship withdrawal provision has certain disadvantages. For employers, it increases the adminis­trative burden of operating the plan; for employees, making preretirement withdrawals can sig­nificantly drain retirement savings. Unlike loans, hardship distributions are not repaid to the plan. Thus, a hardship distribution permanently reduces an employee’s account balance under the plan.

While administering a hardship distribution program can be complicated, a thorough understanding of the plan document results in fewer mistakes—and employees tend to feel more comfortable building their retirement accounts knowing that their 401(k)s can be put to use in the event of an emergency.

Here, we’ll look at some of the rules for hardship withdrawals, courtesy of The 401(k) Handbook.

Hardship Withdrawal of Employee Deferrals Permitted

Although a 401(k) plan generally may not distribute an employee’s elective defer­rals before the employee separates from service, it may provide for the hardship withdrawal of employee deferrals. Additionally, a plan may allow for the distribution, regardless of hardship, of other contributions made to the plan on behalf of the employee (that is, matching and nonmatching employer contributions) after the contributions have been in the plan for at least 2 years, as long as those contributions were not used to satisfy the actual deferral percent­age (ADP) test. Contributions that have been used to satisfy the ADP test generally are not eligible for hardship withdrawal.

A plan’s hardship withdrawal rules must restrict employees’ access to their account money. A plan may provide for hardship withdrawals only in the event of an immediate and heavy financial need and when the withdrawal is necessary to satisfy that need.

Determinations of need must be made under the general “facts-and-circumstances” tests and/or the “deemed” hardship safe harbors provided in the IRS regulations on plan distributions. The determinations of the need and the amount must be based on nondiscriminatory and objective standards set forth in the plan.

The administrator of a plan that provides for hardship withdrawals should ensure that a withdrawal satisfies one of these two tests. Failure to substantiate compliance with the hardship requirements can result in a disqualifying plan distribution.

For administrative convenience, many plans limit the number of hardship withdrawals that an employee can make during a particular period, process withdrawals only at the end of a plan quarter, and establish a minimum withdrawal amount. Most plans also allow employees to des­ignate the investment vehicle from which the withdrawal is to be made. Although a plan may charge an administrative fee for processing withdrawal requests, most plans do not do so.

Taxation of Hardship Withdrawals

Hardship withdrawals generally are includable in the employee’s income, and are subject to an additional tax of 10% of the taxable amount, unless the withdrawal is made after the employee attains age 59½ or becomes disabled, or the amounts are used for deductible medical ex­penses. The amount of the hardship withdrawal must be reported on the Form 1099-R issued to the employee.

Note that plans are not required to offer hardship withdrawal provisions. Even if they do provide for such withdrawals, plans may choose to drop the provision. While the anticutback rules of Code Section 411(d)(6) generally prevent a qualified plan from restricting or eliminating certain types or forms of benefits, such as the timing of plan distributions, a special rule allows a plan to be amended to restrict or even eliminate its hardship withdrawal provisions without violating these anti-cutback rules.

Spousal Consent

Most 401(k) plans are not subject to spousal consent requirements because they do not pro­vide for annuity distributions; rather, they provide for paying the account balance to the surviv­ing spouse in the event of the employee’s death. If the 401(k) plan is subject to spousal consent requirements, however, when a hardship withdrawal is made by a married employee, the plan administrator also must obtain the written, witnessed consent of the employee’s spouse, unless:

• The plan is not subject to the joint and survivor annuity rules of Code Sections 401(a)(11) and 417, or
• The employee’s benefit is less than $5,000.

Tips for Avoiding Administrative Mistakes

Here are some ways plan sponsors can minimize the risk of hardship-related mistakes:

• Review plan document language to determine when and under what circumstances distributions can be made;
• Ensure the language regarding hardship distribu­tions is contained in the most recent plan document;
• Establish hardship distribution procedures and work with benefit professionals to determine if they are sufficient to avoid mistakes;
• Allow only those hardship distributions that meet the re­quirements of Code Section 401(k) and the plan document;
• Confirm that the hardship distribution program is not being abused or mismanaged: Watch out for too many hardship requests by one group or division (e.g., highly compensated employees), and confirm that each request is unique. Multiple identical-looking requests can be a red flag for fraud.

Additional Resources

• How to Explain the 401(k) to Your Employees (PPT)
• Summary Plan Description (Standard)
• 401(k) 101: A Benefit for Employers and Employees Alike