Requests for hardship distributions from qualified retirement plans are not unusual in the aftermath of the Great Recession. Some participants may unfortunately be struggling through economic setbacks such as job loss for themselves or their spouse. Internal Revenue Service (IRS) auditors look closely at a retirement plan’s internal controls for processing such hardship distributions. This includes careful review of the documentation used to substantiate these withdrawals. The following is an overview of the issues involved to help keep your plan on track.
Who Qualifies For A Hardship Distribution?
A retirement plan may allow participants to receive hardship distributions but is not actually required to allow hardship distributions. According to the IRS, a distribution can only be made because of an “immediate and heavy financial need” by the participant and must be limited to the amount necessary to satisfy that need. The onus is on the employer to determine the existence of the financial need based on the terms of the plan and all the relevant facts and circumstances. Unless the employer has actual knowledge to the contrary, the employer may rely on the employee’s written statement that the need cannot be relieved from other available resources.
Qualifications for Hardship Distributions
A participant is automatically considered to have an immediate and heavy financial need if the distribution is for:
How Much Can Be Distributed?
The amount of a hardship distribution is limited to the amount needed to cover the immediate and heavy financial need when the employee cannot reasonably obtain the funds from another source.
In a 401(k) plan, hardship distributions can generally only be made from:
- Accumulated elective deferrals and not from earnings on those elective deferrals.
- Employer contributions, sometimes referred to as “profit-sharing contributions.”
- Regular matching employer contributions.
What Participants Should Know
When requesting hardship withdrawals, participants need to understand both the short- and long-term consequences which can impact their retirement plan outcomes.
In the short-term:
- Hardship withdrawals are subject to income taxes and a 10% early withdrawal penalty*. When the administrator processes the withdrawal, typically 10% of the gross amount is withheld for federal tax withholding.
- Participants who take hardship distributions cannot repay the amount taken back to the plan.
- The employee is not allowed to make elective deferrals or contributions to the plan for at least six months after the hardship distribution.
- If the employer does any sort of matching contribution, the participant would also lose out on these contributions during the six month suspension period.
- Some plans may charge a fee to take a hardship withdrawal.
When you factor in these short-term consequences in terms of costs and tax penalties, the participant will need to take out more than they originally planned to receive the amount they actually need. The following example illustrates the real cost of hardship withdrawals.
In this example:
- Susan needs to withdraw $10,000 to pay for tuition for her daughter.
- Susan is in the 25% tax bracket and under the age of 59 ½.
- There is a $100 fee to take a withdrawal from her employer’s 401(k) plan.
Susan would actually need to take out $15,484 to get the $10,000 she needs to cover tuition.
In the long-term:
One of the biggest consequences of taking a hardship withdrawal is the lost opportunity of compounding interest earned over time on the amount withdrawn. As a result of her $15,484 withdrawal for tuition, Susan will miss out on the thousands that would have accumulated on those monies over time.
- If we assume that Susan is 50 years old.
- There is a 7% rate of return each year on her retirement account.
- $15,484 would have grown to a future value of $42,720 by the time she reached age 65.
In addition, when you factor in the amount that was not contributed to her 401(k) plan during the six-month period after her hardship withdrawal, her lost opportunity in terms of potential dollars earned is even larger.
A Last Resort
As Benjamin Franklin once said, “A penny saved is a penny earned.” Withdrawing money from a retirement plan should truly be the last resort for any participant. The more a participant can be educated and informed of the possible financial consequences of a hardship withdrawal, the better equipped they will be to make a decision that is truly in their best interests in the long-term. In addition, from the plan sponsor’s perspective careful record keeping of hardship withdrawals is key.
To learn more about hardship disbursements from a retirement plan, contact your local ABG Representative.