Complying with Hardship Withdrawal Rules Makes Retirement Plan Administration Easy (Well, Easier, Anyway)
In a February 2018 article, my colleague Kathleen Dreyfus Bardunias encouraged retirement plan sponsors to implement annual “operational checkups” in order to ensure their plans were administered in compliance with the plan’s terms and applicable law. That article described various retirement plan administration errors that review might uncover, including: failing to timely deposit employee contributions, failing to provide required notices, and plan loan failures.
While the prior article didn’t specifically explore errors in the administration of hardship withdrawals, the recent IRS guidance and legislative changes discussed below show that this is an area where both plan sponsors and participants may still have questions.
Background – the (Very Basic) Basic Rules of Hardship Withdrawals
Only defined contribution plans (such as Code §§401(k) and 403(b) plans) allowing employees to make elective deferrals can offer hardship withdrawals. Plan sponsors may, but are not required to, design their plans to permit participants to request in-service distributions to alleviate certain financial hardships.
Under Treasury Reg. §1.401(k)-1(d)(3), a plan participant may request a hardship withdrawal if the participant: (i) has an “immediate and heavy financial need,” and (ii) lacks the financial resources to satisfy that need. The hardship withdrawal cannot exceed the amount needed to satisfy the participant’s financial need.
Whether a participant’s situation constitutes an immediate and heavy financial need is generally based on the relevant facts and circumstances. However, these events are “safe harbors” – i.e., deemed to give rise to an immediate and heavy financial need:
Medical care expenses for the participant, his/her spouse, dependents, or beneficiaries
Costs directly related to the participant’s purchase of his/her principal residence (not including mortgage payments)
Amounts necessary to prevent the participant’s eviction from, or foreclosure on, the participant’s principal residence
Funeral expenses for the participant, his/her spouse, dependents, or beneficiaries
Expenses incurred to repair damage to the participant’s principal residence; and
Tuition and related expenses (fees, room and board, etc.) for the next 12 months of post-secondary education for the participant, his/her spouse, dependents, or beneficiaries
The last item was the subject of recent IRS guidance.
IRS Interpretative Guidance
In early 2018, the IRS issued informal guidance responding to a plan participant’s question about whether he could pay student loan debt using a hardship withdrawal. In its short response, the IRS clarified that hardship withdrawals can only be taken to pay for educational expenses expected to be incurred in the future. Paying student loans, the IRS noted, was not payment for prospective educational expenses, and so hardship withdrawals are not available for such expenses.
While it might seem like there is little difference between paying expenses in advance and paying off student loan debt, the Internal Revenue Service’s position makes sense from a policy perspective. That is, if the plan participant was able to obtain a loan to pay for educational expenses, he didn’t lack the financial resources necessary to pay for them. Accordingly, no hardship existed (at least for purposes of the Code).
Impact of New Tax Legislation
Recent legislative changes will make it easier for participants to obtain hardship withdrawals. However, they may also complicate the administration of hardship withdrawals, providing additional opportunities for things to go wrong.
For instance, beginning in 2019, participants will no longer need to obtain all available plan loans before requesting hardship withdrawals, nor will they be prohibited from making elective contributions to their retirement plans for six months following the withdrawal. Employers may also allow participants to take hardship withdrawals from additional types of contributions (such as profit sharing contributions and qualified matching contributions), increasing the amounts available for hardship withdrawals.
Correcting Hardship Withdrawal Errors
Some common hardship withdrawal errors – such as failing to suspend participant elective contributions following a withdrawal – will be alleviated by the legislation discussed above. Others, such as allowing hardship withdrawals when not permitted by the plan document or allowing withdrawals for impermissible reasons, will continue to be concerns.
The IRS permits plan sponsors to self-correct some errors (such as allowing hardship withdrawals when the plan does not permit them) under the Internal Revenue Service’s Employee Plans Compliance Resolution System (EPCRS) correction program. Self-correction is not available in all instances, however. A plan sponsor must submit a voluntary compliance program (VCP) application to the IRS to correct “significant” (as defined by EPCRS) hardship withdrawal errors, and pay the required compliance fee (and any legal and other fees incurred to prepare the application).
Avoiding Hardship Withdrawal Errors
Even if hardship withdrawal errors can be corrected, plan sponsors will no doubt prefer to avoid them. The IRS suggests that a plan sponsor first review its 401(k)/403(b) plan document to determine whether the document provides for hardship withdrawals. If so, then, as part of its annual operational checkup, the sponsor should compare the plan document and its hardship withdrawal procedures to ensure the events for which hardship withdrawals can be requested match. If they don’t, a correction may be needed. Plan sponsors should also review the hardship withdrawal requests processed during the year to ensure they meet the plan’s requirements and have been properly documented.
If the operational checkup uncovers errors in the plan sponsor’s hardship withdrawal program, the sponsor should take steps to correct them – whether through self-correction or by filing a VCP application. Violating the Code’s hardship withdrawal rules may cause the loss of a plan’s tax-qualified status, which would be a “hardship” for both the plan’s sponsor and its participants!