Retirement plans are not required to provide hardship distributions. However, many profit sharing plans, including 401(k) plans, do. If a participant in a plan with a hardship provision has an immediate and heavy financial need, and the need matches the plan’s definition of hardship, the participant may be eligible for a distribution (restrictions and limits apply).
It’s natural to feel badly when someone is in need. However, authorizing a plan distribution that does not meet the requirements can disqualify the entire plan and lead to adverse tax consequences for plan participants and for the plan sponsor. It is important for sponsors to understand the hardship rules and to have procedures in place for making distributions and documenting a participant’s need in a manner that will satisfy the IRS in case the plan is chosen for examination.
Six safe harbor reasons
There are six safe harbor reasons that satisfy the immediate and heavy need requirement in most prototype plans. They are:
- Unreimbursed medical expenses deductible under Internal Revenue Code Section 213(d) for the participant or the participant’s spouse, dependents, or beneficiaries
- The purchase of a principal residence
- Tuition and related educational fees and room and board expenses for up to the next 12 months of post-secondary education for the participant or the participant’s spouse, children, dependents, or beneficiaries
- To prevent eviction from or foreclosure on the principal residence
- Funeral expenses for the participant or the participant’s spouse, dependents, or beneficiaries
- Expenses for the repair of a principal residence due to hurricane, flood, and other casualty deduction reasons
Other sources first
If a participant has other resources available that can satisfy his or her financial need, those should be used first. For prototype plans, all other plan distributions must be taken before a hardship may be requested, including a participant loan. Note: There are two exceptions to this requirement. A loan would not have to be taken first if 1) the loan repayments would make the hardship worse or 2) a participant is purchasing a principal residence and taking a plan loan would prevent the participant from getting financing.
For individually designed plans or volume submitter plans using the “facts and circumstances test” to determine hardship, participants must first make use of all reasonably available personal assets, regardless of whether they are plan related.