In an ideal world, we
would all contribute as much money as possible to our retirement
plans and allow it to grow until we were ready to retire. We could
then enjoy our twilight years with comfort and security, be it
traveling the world or relaxing by the pool.
In the real world, life doesn’t always go as planned. Doctor
bills, college tuition and personal emergencies can arise and stress
our finances to the max. During these times an employee may be
relieved to know that his retirement account, though intended for
retirement, is also available for financial hardship.
The type of retirement plan most likely to offer hardship
distributions is the ever-popular 401(k) plan, funded primarily by
employee salary deferrals. Section 403(b) and section 457(b) plans
are also funded by salary deferrals and are likely to permit
hardship distributions as well. However, such distributions are not
limited to deferral accounts and other accounts under a profit
sharing plan may provide them.
What follows is a close-up look at the rules concerning hardship
distributions, including some provisions added by final regulations
that many plans will incorporate this year. It also includes special
provisions adopted last year to provide relief to victims of
Hurricane Katrina.
Salary Deferral vs. Employer Accounts
The overwhelming majority of hardship distributions are dispensed
from participants’ 401(k) (salary deferral) accounts. In fact,
hardship is the only allowable reason for an in-service distribution
from salary deferral accounts prior to age 59½ (other than plan
termination without an alternative plan).
Profit sharing plans may allow in-service distributions of
employer-funded benefits (e.g., match or profit sharing
contributions) prior to age 59½, conditioned upon the occurrence of
a specified event. One of the eligible events is a participant’s
financial hardship. The rules applicable to these hardship
distributions are less restrictive than for salary deferral
accounts.
For hardships from employer-funded benefits, the plan must define
hardship and establish rules that are applied in a uniform,
consistent manner. However, in order to simplify plan
administration, some plan documents apply the more restrictive
salary deferral hardship withdrawal requirements to hardship
withdrawals from employer-funded accounts.
The plan may permit the entire vested employer-funded account
balance to be distributed, including earnings. Employer qualified
nonelective contributions (QNEC) and qualified matching
contributions (QMAC), made for purposes of passing nondiscrimination
testing, may not be distributed as in-service distributions unless
the employee has attained age 59½. An exception applies for QNECs
and QMACs credited prior to January 1, 1989 (or if later, plan years
ending prior to July 1, 1989).
The rules for salary deferral hardship distributions are more
complicated. Let’s take a look at those rules.
Distributions From Deferral Accounts
The first requirement is that the withdrawal be on account of an
immediate and heavy financial need of the participant. In addition,
the withdrawal must not exceed the amount necessary to satisfy the
need. These determinations are made in accordance with objective and
nondiscriminatory standards set forth in the plan document.
Financial Need
The determination as to whether or not a participant has an
immediate and heavy financial need is based on the relevant facts
and circumstances of each case. However, the regulations provide a
"safe harbor" list of events which will automatically be deemed to
satisfy the financial need requirement. The list is as follows:
- Expenses for, or necessary to obtain medical care for the
employee, the spouse or dependents (including a non-custodial
child) that would be deductible under section 213 of the Internal
Revenue Code (IRC), regardless of whether the expenses exceed 7.5%
of adjusted gross income;
- Costs directly related to the purchase of a principal
residence for the employee (excluding mortgage payments);
- Payment of tuition, related educational fees and room and
board expenses for up to the next 12 months of post-secondary
education for the employee, the spouse, children or dependents;
- Payments necessary to prevent the eviction of the employee
from his principal residence or foreclosure on the mortgage on
that residence;
- Payments for burial or funeral expenses for the employee’s
parent, spouse, child or dependent; or
- Expenses for the repair of damage to the employee’s principal
residence that would qualify for the casualty deduction under IRC
section 165, whether or not the loss exceeds 10% of adjusted gross
income.
The last two items on the list were added by the final 401(k)
regulations, effective for plan years beginning after December 31,
2005. Plans had the ability to incorporate the changes earlier, as
of plan years ending after December 29, 2004, but only if all of the
provisions of the final regulations were implemented at the same
time. The hardship provisions of the final regulations can only be
utilized after the plan document has been appropriately amended.
Plans may utilize the safe harbor definition of financial need or
establish their own criteria under the facts and circumstances test.
The regulations give some examples of what may reasonably be
considered financial need, and certainly the safe harbor list can
also serve as a guideline.
Satisfaction of the Financial Need
Once the existence of a financial need is established, a
participant must show that a distribution from his salary deferral
account is necessary to satisfy the need. Under the facts and
circumstances test, the following items must be satisfied:
- The distribution must not exceed the amount of the need, plus
any federal, state and local taxes and penalties that may result
from the distribution, and
- There are no alternative means available. Alternative means
includes assets of the employee’s spouse and minor children that
are reasonably available to the employee. The employer may rely on
the employee’s written statement that no other resources are
available, absent specific knowledge to the contrary that the need
can be satisfied by:
- Reimbursement or compensation by insurance or otherwise;
- Liquidation of employee’s assets;
- Cessation of elective or other employee contributions to the
plan;
- Other currently available distributions and loans from plans
maintained by any employer; or
- Borrowing from commercial sources on reasonable terms.
However, the employee would not be expected to take such other
action if the effect would be to increase the need.
A plan can choose to utilize a safe harbor test in which case the
distribution will be deemed necessary to satisfy the need if the
following two conditions are met:
- The employee has obtained all other currently available
distributions and loans from all plans maintained by the employer,
and
- The employee is prohibited from making elective and other
employee contributions to any plan maintained by the employer for
at least six months after receipt of the hardship distribution.
The term "all plans of the employer" means all qualified and
non-qualified plans. The six-month suspension rule does not apply to
mandatory employee contributions to a defined benefit plan or to a
health or welfare benefit plan. In plans that provide safe harbor
matching contributions to avoid nondiscrimination testing, the
suspension period cannot exceed six months.
Benefits Available For Distribution
Regardless of the amount of financial need, a hardship
distribution cannot exceed the amount of available benefits in the
participant’s salary deferral account. Generally, the available
benefits are limited to the aggregate contributions made by the
participant up to the date of distribution, reduced by any prior
deferral distributions. Earnings on salary deferrals are not
included, other than those credited prior to January 1, 1989 (or if
later, plan years ending prior to July 1, 1989).
Example: Diane needs $10,000 for the purchase of a primary
residence. She has no other source of funds at her disposal. Her
401(k) plan allows participant loans as well as hardship
distributions, and the rules require that all available loans be
taken first. But the additional debt of a plan loan would disqualify
her from obtaining the mortgage she needs to purchase the home. She
is therefore approved for a hardship distribution.
The current value of Diane’s deferral account is $14,000, of
which $9,500 represents her aggregate contributions since she
entered the plan in 2001. The maximum withdrawal Diane can take is
$9,500, and she would have to suspend contributions to the plan for
the next six months in accordance with the provisions of her plan.
Taxation of Hardship Distributions
Hardship distributions are taxable in the year received and will
be subject to an additional 10% early withdrawal penalty if the
participant has not reached age 59½. Such distributions are not
eligible for rollover to an IRA or another qualified employer plan.
They are subject to 10% tax withholding which may be waived by the
participant.
Hurricane Katrina Victims
On September 15, 2005 the Internal Revenue Service (IRS) and the
Department of Labor provided unprecedented broad-based relief for
those adversely affected by Hurricane Katrina. IRS Announcement
2005-70 provided guidelines for the relaxation of administrative
rules governing plan loans and hardship distributions to Katrina
victims and members of their families who participate in retirement
plans. The relief made it easier for these participants to establish
financial need by allowing plan administrators to rely on
representations by the participant, absent actual knowledge to the
contrary. In addition, the minimum six-month contribution suspension
period after receiving a hardship withdrawal was eliminated. Plans
that didn’t provide for loans or hardship distributions could
process withdrawals regardless and amend the plan at a later date.
The special rules applied to loans and hardship distributions made
between August 29, 2005 and March 31, 2006.
Conclusion
The availability of hardship distributions from salary deferral
plans is one of many factors that encourage employee participation.
Knowing that the money can be withdrawn if needed provides a sense
of security. The hardship rules are intended to limit distributions
to times of serious financial need and support the long-term goal of
saving for retirement. But the recent expansion of the hardship
criteria illustrates that the rules are intended to be fair and keep
pace with the changing needs of employees.
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