In an ideal world, we would all
contribute as much money as possible to our retirement plans and allow it to
grow until we were ready to retire. We could then enjoy our twilight years
with comfort and security, be it traveling the world or relaxing by the
pool.
In the real world, life doesn’t always go as planned. Doctor bills,
college tuition and personal emergencies can arise and stress our finances
to the max. During these times an employee may be relieved to know that his
retirement account, though intended for retirement, is also available for
financial hardship.
The type of retirement plan most likely to offer hardship distributions
is the ever-popular 401(k) plan, funded primarily by employee salary
deferrals. Section 403(b) and section 457(b) plans are also funded by salary
deferrals and are likely to permit hardship distributions as well. However,
such distributions are not limited to deferral accounts and other accounts
under a profit sharing plan may provide them.
What follows is a close-up look at the rules concerning hardship
distributions, including some provisions added by final regulations that
many plans will incorporate this year. It also includes special provisions
adopted last year to provide relief to victims of Hurricane Katrina.
Salary Deferral vs. Employer Accounts
The overwhelming majority of hardship distributions are dispensed from
participants’ 401(k) (salary deferral) accounts. In fact, hardship is the
only allowable reason for an in-service distribution from salary deferral
accounts prior to age 59½ (other than plan termination without an
alternative plan).
Profit sharing plans may allow in-service distributions of
employer-funded benefits (e.g., match or profit sharing contributions) prior
to age 59½, conditioned upon the occurrence of a specified event. One of the
eligible events is a participant’s financial hardship. The rules applicable
to these hardship distributions are less restrictive than for salary
deferral accounts.
For hardships from employer-funded benefits, the plan must define
hardship and establish rules that are applied in a uniform, consistent
manner. However, in order to simplify plan administration, some plan
documents apply the more restrictive salary deferral hardship withdrawal
requirements to hardship withdrawals from employer-funded accounts.
The plan may permit the entire vested employer-funded account balance to
be distributed, including earnings. Employer qualified nonelective
contributions (QNEC) and qualified matching contributions (QMAC), made for
purposes of passing nondiscrimination testing, may not be distributed as
in-service distributions unless the employee has attained age 59½. An
exception applies for QNECs and QMACs credited prior to January 1, 1989 (or
if later, plan years ending prior to July 1, 1989).
The rules for salary deferral hardship distributions are more
complicated. Let’s take a look at those rules.
Distributions From Deferral Accounts
The first requirement is that the withdrawal be on account of an
immediate and heavy financial need of the participant. In addition, the
withdrawal must not exceed the amount necessary to satisfy the need. These
determinations are made in accordance with objective and nondiscriminatory
standards set forth in the plan document.
Financial Need
The determination as to whether or not a participant has an immediate and
heavy financial need is based on the relevant facts and circumstances of
each case. However, the regulations provide a "safe harbor" list of events
which will automatically be deemed to satisfy the financial need
requirement. The list is as follows:
- Expenses for, or necessary to obtain medical care for the employee,
the spouse or dependents (including a non-custodial child) that would be
deductible under section 213 of the Internal Revenue Code (IRC),
regardless of whether the expenses exceed 7.5% 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 the next 12 months of post-secondary education for the
employee, the spouse, children or dependents;
- Payments necessary to prevent the eviction of the employee from his
principal residence or foreclosure on the mortgage on that residence;
- Payments for burial or funeral expenses for the employee’s parent,
spouse, child or dependent; or
- Expenses for the repair of damage to the employee’s principal
residence that would qualify for the casualty deduction under IRC section
165, whether or not the loss exceeds 10% of adjusted gross income.
The last two items on the list were added by the final 401(k)
regulations, effective for plan years beginning after December 31, 2005.
Plans had the ability to incorporate the changes earlier, as of plan years
ending after December 29, 2004, but only if all of the provisions of the
final regulations were implemented at the same time. The hardship provisions
of the final regulations can only be utilized after the plan document has
been appropriately amended.
Plans may utilize the safe harbor definition of financial need or
establish their own criteria under the facts and circumstances test. The
regulations give some examples of what may reasonably be considered
financial need, and certainly the safe harbor list can also serve as a
guideline.
Satisfaction of the Financial Need
Once the existence of a financial need is established, a participant must
show that a distribution from his salary deferral account is necessary to
satisfy the need. Under the facts and circumstances test, the following
items must be satisfied:
- The distribution must not exceed the amount of the need, plus any
federal, state and local taxes and penalties that may result from the
distribution, and
- There are no alternative means available. Alternative means includes
assets of the employee’s spouse and minor children that are reasonably
available to the employee. The employer may rely on the employee’s written
statement that no other resources are available, absent specific knowledge
to the contrary that the need can be satisfied by:
- Reimbursement or compensation by insurance or otherwise;
- Liquidation of employee’s assets;
- Cessation of elective or other employee contributions to the plan;
- Other currently available distributions and loans from plans
maintained by any employer; or
- Borrowing from commercial sources on reasonable terms.
However, the employee would not be expected to take such other action if
the effect would be to increase the need.
A plan can choose to utilize a safe harbor test in which case the
distribution will be deemed necessary to satisfy the need if the following
two conditions are met:
- The employee has obtained all other currently available distributions
and loans from all plans maintained by the employer, and
- The employee is prohibited from making elective and other employee
contributions to any plan maintained by the employer for at least six
months after receipt of the hardship distribution.
The term "all plans of the employer" means all qualified and
non-qualified plans. The six-month suspension rule does not apply to
mandatory employee contributions to a defined benefit plan or to a health or
welfare benefit plan. In plans that provide safe harbor matching
contributions to avoid nondiscrimination testing, the suspension period
cannot exceed six months.
Benefits Available For Distribution
Regardless of the amount of financial need, a hardship distribution
cannot exceed the amount of available benefits in the participant’s salary
deferral account. Generally, the available benefits are limited to the
aggregate contributions made by the participant up to the date of
distribution, reduced by any prior deferral distributions. Earnings on
salary deferrals are not included, other than those credited prior to
January 1, 1989 (or if later, plan years ending prior to July 1, 1989).
Example: Diane needs $10,000 for the purchase of a primary
residence. She has no other source of funds at her disposal. Her 401(k) plan
allows participant loans as well as hardship distributions, and the rules
require that all available loans be taken first. But the additional debt of
a plan loan would disqualify her from obtaining the mortgage she needs to
purchase the home. She is therefore approved for a hardship distribution.
The current value of Diane’s deferral account is $14,000, of which $9,500
represents her aggregate contributions since she entered the plan in 2001.
The maximum withdrawal Diane can take is $9,500, and she would have to
suspend contributions to the plan for the next six months in accordance with
the provisions of her plan.
Taxation of Hardship Distributions
Hardship distributions are taxable in the year received and will be
subject to an additional 10% early withdrawal penalty if the participant has
not reached age 59½. Such distributions are not eligible for rollover to an
IRA or another qualified employer plan. They are subject to 10% tax
withholding which may be waived by the participant.
Hurricane Katrina Victims
On September 15, 2005 the Internal Revenue Service (IRS) and the
Department of Labor provided unprecedented broad-based relief for those
adversely affected by Hurricane Katrina. IRS Announcement 2005-70 provided
guidelines for the relaxation of administrative rules governing plan loans
and hardship distributions to Katrina victims and members of their families
who participate in retirement plans. The relief made it easier for these
participants to establish financial need by allowing plan administrators to
rely on representations by the participant, absent actual knowledge to the
contrary. In addition, the minimum six-month contribution suspension period
after receiving a hardship withdrawal was eliminated. Plans that didn’t
provide for loans or hardship distributions could process withdrawals
regardless and amend the plan at a later date. The special rules applied to
loans and hardship distributions made between August 29, 2005 and March 31,
2006.
Conclusion
The availability of hardship distributions from salary deferral plans is
one of many factors that encourage employee participation. Knowing that the
money can be withdrawn if needed provides a sense of security. The hardship
rules are intended to limit distributions to times of serious financial need
and support the long-term goal of saving for retirement. But the recent
expansion of the hardship criteria illustrates that the rules are intended
to be fair and keep pace with the changing needs of employees.
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