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Retirement Plans – 7 Steps to Making a Hardship Distribution

During the course of my benefit plan audit practice, I often run across plan sponsors and administrators who are not quite clear on the hardship distribution rules.

This information – which I pulled out of the IRS’s Retirement News for Employers Newsletter – is helpful in understanding how Hardship Distributions should work.

In these challenging economic times, participants may seek hardship distributions from their retirement plan. Before making hardship distributions, review the steps below to make sure you follow both the legal requirements and your plan’s requirements.

The law states that some retirement plans (for example, 401(k) and 403(b) plans) may allow participants to withdraw certain amounts from the plan because of a financial hardship. IRS regulations provide guidelines for plans to follow to ensure they satisfy the law’s requirements. A plan can make a hardship distribution only:

if permitted by the plan;

because of an immediate and heavy financial need of the employee and, in certain cases, of the employee’s spouse, dependent or beneficiary; and in an amount necessary to meet the financial need .

Step 1 – Review the terms of your plan, including:
whether the plan allows hardship distributions; the procedures the employee must follow to request a hardship distribution; the plan’s definition of a hardship; and any limits on the amount and type of funds that can be distributed as a hardship from an employee’s accounts.

Step 2 – Ensure that the employee complies with the plan’s procedural requirements. For example, make sure the employee has provided a statement or verification of his or her hardship in the form required by the plan.

Step 3 – Verify that the employee’s specific reason for hardship qualifies for a distribution using the plan’s definition of what constitutes a hardship. For instance, the plan may limit a hardship distribution to pay burial or funeral expenses and not for any other reason.

Step 4 – If the plan, or any of your other plans in which the employee is a participant, offers loans, document that the employee has exhausted them prior to receiving a hardship distribution. Likewise, verify that the employee has taken any other available distributions, other than hardship distributions, from these plans.

Under some plans, a hardship distribution is not considered necessary if the employee has other resources available, such as spousal and minor children’s assets (excluding property held for the employee’s child under an irrevocable trust or under the Uniform Gifts to Minors Act).

Step 5 – Check that the amount of the hardship distribution does not exceed the amount necessary to satisfy the employee’s financial need. However, the amount required to satisfy the financial need may include amounts necessary to pay any taxes or penalties that are due because of the hardship distribution.

Step 6 – Make sure that the amount of the hardship distribution does not exceed any limits under the plan and is made only from the amounts eligible for a hardship distribution. For example, the plan may permit a hardship distribution of only 50% of an employee’s salary reduction contributions.

Step 7 – Most plans also specify that the employee is suspended from contributing to the plan and all other plans that the employer maintains for at least six months after receiving a hardship distribution. Inform the employee and enforce this provision! Failing to enforce the plan’s suspension provision is a common plan error but may be corrected through the Employee Plans Compliance Resolution System (EPCRS).

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