Navigating the Shoals of 401(k) Hardship Withdrawals
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Navigating the Shoals of 401(k)
Permitting hardship withdrawals is a mixed bag. On the plus side, some
employees might not agree to join the plan if they lack the freedom to tap
their accounts in a crisis. On the negative side, allowing withdrawals may
cause some employees to look upon the plan as more of a short-term savings
vehicle. Also, handling hardship withdrawal processing can chew up
administrative resources and provide more opportunities to incur the wrath
of the IRS.
And, employees who jump through the necessary hoops to receive a hardship
withdrawal will pay a big price -- the same as they would with a garden
variety premature withdrawal: Taxation on the withdrawal, plus a 10 percent
tax penalty (for employees under the age of 59 1/2).
That penalty is waived, however, if the employee:
• Is completely disabled,
• Has medical bills exceeding 7.5 percent of income,
• Needs the funds to prevent being evicted or foreclosed upon for
a primary residence, and
• Is leaving your employ.
Permitted Withdrawal Circumstances
Hardship withdrawals are allowable under the following circumstances -- but
you as the plan sponsor can choose which ones you will deem worthy of a
hardship withdrawal (including none). These withdrawals can help to pay for:
• A primary home,
• Education tuition, room and board, and fees for the next 12 months for
the employee, the employee's spouse or other dependents,
• Unreimbursed medical expenses,
• Funeral expenses for immediate family members, and
• "Severe financial hardship."
Employees must exhaust other resources, generally including plan loans, if
you allow them, before requesting a hardship withdrawal. The IRS allows
employees to take hardship withdrawals without seeking a plan loan under
1. Interest on the loan would put the employee in an even more desperate
2. the new debt would disqualify the employee from taking out a mortgage
on a principal residence.
Keep in mind that if you allow hardship withdrawals to be taken which do not
satisfy IRS requirements, you risk disqualifying your plan. Disqualification
comes with potentially huge adverse tax consequences for you and your
employees. That puts a burden on you, to some extent, to verify an employee
seeking a hardship withdrawal is indeed facing the circumstances which make
him or her eligible for the distribution.
While you can rely on an employee's written statement attesting to the truth
of the hardship circumstance, the IRS also expects you to look for any
documentation which would back up those claims. For example, if an
employee seeks a hardship withdrawal to finance college expenses, request a
copy of the invoice.
Sometimes you may need to split hairs and rely closely on the fine print of IRS
definitions. For example, suppose an employee wants to use a hardship
withdrawal to pay for the cost of having an unsightly (but noncancerous)
mole removed from his face. Would this be allowable?
The answer depends on the definition of "medical care." As defined in
Internal Revenue Code Section 213(d)(1), medical care refers to sums paid
• The diagnosis, cure, mitigation, treatment, or prevention of disease, for
the purpose of affecting any structure or function of the body,
The amount of the permitted withdrawal can be enough not only to cover the
immediate need, but taxes and penalties associated with taking the
• Transportation to receive services described above,
• Qualified long-term care services, and
• Insurance (including amounts paid as premiums under … the Social
Security Act) relating to supplementary medical insurance for the aged.
Typical Trouble Spots
What kind of trouble do employers typically run into administering hardship
withdrawals? The IRS has issued a list of the leading offenses. At the top of
the list is allowing hardship withdrawals for purposes not specifically
permitted in the plan's governing document. Implication: Read the list before
agreeing to a hardship withdrawal.
Here are some more areas where employers find themselves in trouble during
Remember, you do not have to allow hardship withdrawals. But if you do, be prepared
to commit the administrative resources required to handle them correctly.
• Unclear definitions of "hardship" or procedures for taking a qualified
• Failure to specify the category of 401(k) account funds eligible for
withdrawal. For example, ever since 1988, only employee deferral
amounts have been eligible for hardship withdrawals, but not investment
earnings on those deferrals,
• Lack of an explanation that funds in employees' 401(k) accounts which
got there via rollovers and transfers from other accounts are eligible for
hardship withdrawals, and
• Failure to maintain adequate records documenting plan participants'
eligibility for the hardship withdrawals they have taken.