You’ve been the benefit administrator with your current employer for a couple of years. During that time, there have been a handful of employees who have requested hardship distributions from their 401(k) plan which you have processed. It isn’t until now, two years later, that in reviewing the plan document you realize hardship distributions are not allowed under the plan! What happens now?
A 401(k) plan may allow employees to receive a hardship distribution because of an immediate and heavy financial need. Hardship distributions from a 401(k) plan are generally limited to the amount of the employee’s elective deferrals and generally don’t include any income earned on the deferred amounts. However, some plans apply the hardship distribution rules to other types of plan contributions. The law permits a hardship distribution only if the distribution is made because of an employee’s immediate and heavy financial need and is necessary to satisfy that financial need. The employer determines whether an employee has an immediate and heavy financial need and the amount of the need based on all relevant facts and circumstances. The law deems a distribution to be made because of an employee’s immediate and heavy financial need if the distribution is for:
- Expenses for (or necessary to obtain) medical care for the employee or the employee’s spouse, children, or dependents;
- Costs directly related to the purchase of the employee’s principal residence (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 or for the employee’s spouse, children, or dependents;
- Payments necessary to prevent eviction from, or foreclosure on, the employee’s principal residence;
- Payments for burial or funeral expenses for the employee’s deceased parent, spouse, children, or dependents; and
- Certain expenses for the repair of damage to the employee’s principal residence.
It is common for 401(k) plans to list these events as the events that make an employee eligible to receive a hardship distribution. It’s important that you keep a record of all information used to determine whether one of these events has occurred and that the amount distributed was the amount necessary to alleviate the hardship. The IRS has recently clarified that the plan sponsor is responsible for requesting and retaining documentation to substantiate the nature of the hardship. It is not permissible to allow the participant to self-certify the nature of the hardship and to agree to retain documentation because the plan sponsor (not the participant) must determine whether a hardship event has occurred and the amount necessary to alleviate the hardship, and if the participant leaves employment or fails to keep the necessary records, the plan sponsor would not be able to produce the necessary records in the event of an IRS audit.
The only thing the participant can self-certify is that the participant does not have other resources to satisfy the need. The plan sponsor may rely on this self-certification unless it knows that the certification is incorrect.
Hardship distributions can’t be rolled over to another plan or IRA and may be subject to the 10% early distribution tax on distributions made prior to reaching age 59 ½.
How to find the mistake:
Review your plan document to determine if it allows hardship distributions, and review your 401(k) plan hardship procedures. If you don’t have procedures for reviewing hardship applications, establish them, possibly with the help of an employee benefits professional.
Review all distributions made during the year and determine which distributions may have been hardship distributions. Make a determination whether each hardship distribution met the hardship distribution legal requirements.
How to fix the mistake:
If the plan document doesn’t allow for hardship distributions, but, in operation, hardship distributions do occur, correction may involve a retroactive amendment to allow hardship distributions. If hardship distributions are made to participants that don’t meet the plan document hardship requirements or the legal requirements for hardship distributions, then correction may involve a repayment to the plan of the amounts that didn’t meet the hardship requirements.
Example 1:
Employer L maintains a 401(k) plan with 40 participants. Plan provisions don’t allow for hardship distributions. Employer L made hardship distributions to some employees during the 2013 and 2014 plan years. During a review of its plan operations, Employer L determined that it had made these hardship distributions available to all employees and that it had met the legal requirements for hardship distributions.
Correction programs available:
Self-Correction Program (“SCP”):
This mistake is considered an operational error. If Employer L determines it has established practices and procedures in place to promote the overall compliance of their plan, it may correct the mistake under the IRS Self-Correction Program (“SCP”). Although, in general, correction of an operational error through plan amendment isn’t permissible under SCP, the provision of hardship withdrawals under the plan in a nondiscriminatory manner is one of four instances in which EPCRS allows a corrective amendment under SCP.
Correction would include adopting a retroactive plan amendment, effective January 1, 2013, to provide for the hardship distributions that Employer L made available. The amendment must provide that the hardship distribution option is available to all employees participating in the plan.
Voluntary Correction Program (“VCP”):
Employer L may also correct the mistake under VCP by adopting a retroactive plan amendment, effective January 1, 2013, to provide for the hardship distributions it made available. The amendment must provide that the hardship distribution option is available to all employees participating in the plan. The fee for the VCP submission, based on a 40-person plan, is $1,000. For more information regarding VCP submission requirements, click here.
Audit Closing Agreement Program:
If this error is discovered through an audit, rather than during Employer’s own review of its plan operations, Employer L may also correct this error under the IRS Audit Closing Agreement Program (“Audit CAP”) (see example 3 below).
Example 2:
Same facts as Example 1, except Employer L didn’t make the distributions available to all employees. Employer L only offered and only made a hardship distribution to one highly compensated employee.
Correction programs available:
Self-Correction Program (“SCP”):
Since Employer L didn’t make hardship distributions available to all employees, correction by retroactive amendment under SCP is not available.
Voluntary Correction Program (“VCP”):
Employer L may correct the mistake under VCP. However, since Employer L didn’t make the hardship distributions available to all employees, but only made them available to one highly compensated employee, EPCRS does not permit a retroactive plan amendment to correct this mistake. The amendment would not satisfy the nondiscrimination rules. Employer L must correct the error under VCP by asking the highly compensated employee who received the impermissible hardship distribution to repay the amount, plus earnings, to the plan. Expecting the participant to repay the amount may pose a problem because the participant may have already spent the funds. Correction will depend on the facts and circumstances and may include, in some form, payback by the participant or by an employer corrective contribution. The fee for the VCP submission, based on a 40-person plan, is $1,000.
Audit Closing Agreement Program (“Audit CAP”):
Employer L may also correct this error under Audit CAP (see example 3 below).
Example 3:
Employer M maintains a 401(k) plan with 7,500 participants. Plan provisions allow for hardship distributions to participants. During a review of its operations, Employer M determined that 10 hardship distributions made during the 2014 plan year didn’t have proper documentation. Employer M also determined that five “hardship” distributions were not based on a permissible hardship, making them in-service distributions that were not permitted under the terms of the plan. in addition, no written procedures were in place to review a participant’s application for a hardship distribution.
Correction programs available:
Self-Correction Program (“SCP”):
This mistake may not be eligible for correction under SCP since adequate practices and procedures for hardship distributions were not in place.
Voluntary Correction Program (“VCP”):
Employer M may correct this mistake under VCP. Employer M must ask the five participants who received distributions not meeting the legal hardship requirements to repay the amounts, plus earnings, to the plan. In addition, Employer M must improve its hardship administrative procedures. Expecting participants to repay these amounts may pose a problem because the participants may have already spent the funds. A plan document requiring spousal consent for distributions, plus possible tax issues on the distributions could further complicate the final correction. Correction will depend on the facts and circumstances of each situation and may include, in some form, paybacks by the participants, paybacks by employer corrective contributions, and plan amendments. If this represents your situation, file a VCP submission and work with the IRS agent to determine the proper correction. The fee for the VCP submission, based on a 7,500-person plan, is $20,000.
Audit Closing Agreement Program (“Audit CAP”):
If this error is discovered through an audit, rather than during Employer M’s own review of its plan operations, Employer M may also correct this error under Audit CAP. Under Audit CAP, the plan sponsor can correct the mistake and pay a negotiated sanction. Sanctions under Audit CAP are a negotiated percentage of the maximum payment amount. The sanction will generally bear a relationship to the nature, extent and severity of the mistake, considering many factors, including the extent to which correction occurred before audit.
How to avoid the mistake:
- Review the plan document language to determine when and under what circumstances you can make distributions.
- When you amend your plan document, make certain the language for hardship distributions is included in the amended document.
- Establish hardship distribution procedures, working with your benefits professional to determine if these procedures are sufficient to avoid mistakes and to comply with legal requirements.
- Only allow hardship distributions that meet the plan document and legal requirements for hardship distributions.
- Look for the following signs that the hardship distribution program is being abused or badly managed:
- Too many hardship requests by one group or division may be a sign of abuse.
- Requests for hardship distributions from multiple employees appear identical. Each request should have its own individual circumstances.
- Only the highly compensated employees have hardship distributions. This may be a sign that rank-and-file employees haven’t been properly notified of the availability of hardship distributions.
401(k) Plan Fix-It Guide
401(k) Plan Overview
EPCRS Overview
401(k) Plan Fix-It Guide (pdf)
401(k) Plan Checklist
Additional Resources