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Retirement Plans – 7 Steps to Making a Hardship Distribution
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).
Learn How to Fix Retirement Plan Errors
By Stacie Clifford Kitts, CPA
For example – Eligible compensation is calculated incorrectly, a payroll run misses the employee contribution deferral, or you forget to timely remit participant contributions to the plan administrator.
When errors occur, its important to make sure you understand how to correct the problem by using the Voluntary Correction Program (“VCP”).
Here is a list of the top ten failures found in the VCP program:
1. Failure to amend the plan for tax law changes by the end of the period required by the law.
This results in a plan failing to operate in accordance with the current law because the plan document has not been amended to affect such change. Currently, the most common law changes that employers have failed to amend their plans for are GUST*, the good faith amendments for EGTRRA** and the Final and Temporary regulations under section 401(a)(9).
2. Failure to follow the plan’s definition of compensation for determining contributions.
Usually, certain types of compensation are excluded, such as bonuses, commissions, or overtime, or certain types of compensation are included where they should have been excluded. This failure can result in participants receiving allocations to their accounts that are either greater than or less than the amount they should have received.
3. Failure to include eligible employees in the plan or the failure to exclude ineligible employees from the plan.
This often occurs in a controlled group situation after a merger or acquisition. Where otherwise eligible employees are excluded, the excluded employees don’t receive an allocation of contributions to which they are entitled. Where ineligible employees are included in the plan, the employer has made additional contributions which it did not need to make to the plan.
4. Failure to satisfy plan loan provisions.
Loan failures often result from the plan sponsor’s failure to withhold loan payments. Where a plan fails to collect loan repayments from participants, the loan is considered defaulted and the participant should be taxed on the loan in the year of default.
5. Impermissible in-service withdrawals.
These requests relate to both defined benefit and contribution plans. The law provides that distributions to participants can be made upon certain events or the attainment of a specific age. This failure involves the circumstance where a distribution is made to a participant where the law or plan terms do not permit a distribution.
6. Failure to satisfy IRC 401(a)(9) minimum distribution rules.
The law requires that a participant receive a distribution when they attain a certain age. This failure involves the plan not making distributions to participants where they have attained the age for required distributions under the law. The law requires that the participant pay an excise tax of 50% on the amount of required distribution if it is not made timely. The Service will, in appropriate cases, waive the excise tax if the plan sponsor requests the waiver in appropriate situations.
7. Employer eligibility failure.
This occurs when an employer adopts a plan that it legally is not permitted to adopt. Common situations are where a government adopts a 401(k) plan or a tax-exempt entity (other than a 501(c)(3) entity or a public educational organization) adopts a 403(b) plan.
8. Failure to pass the ADP/ACP nondiscrimination tests under IRC 401(k) and 401(m).
This failure could result from the employer not using the correct compensation or where the employer excluded eligible employees who elected not to participate in the 401(k) plan.
9. Failure to properly provide the minimum top-heavy benefit or contribution under IRC 416 to non-key employees.
The law requires that if the account balances or accrued benefits of key employees (typically, owners) comprises a substantial portion of the assets of the plan (generally, 60% of plan assets), non-key employees are entitled to receive a minimum benefit or contribution.
10. Failure to satisfy the limits of IRC 415.
Once you have identified an error, you can refer to the following “Fix-It Guides” published by the IRS.
SARSEP Fix-It Guide(User-friendly version is available.)
SEP Fix-It Guide(User-friendly version is available.)
SIMPLE IRA Plan Fix-It Guide(User-friendly version is available.)
Stacie's Tax Stuff 