Ineligible Hardship Distributions

For years hardship distributions have helped participants deal with unexpected downturns that present serious financial challenges.  While these distributions have been available for several years, the SECURE Act 2.0 made important changes that streamline the administration process by allowing plan sponsors to accept participant self-certification. The change reduces the amount of paperwork and compliance hurdles for plan administrators. Since plans are not required to offer this benefit, the recent change is designed to encourage more plans to participate.

While a useful benefit, plan sponsors need to become familiar with the rules governing these distributions. This includes what triggers a hardship event, how the distributions are to be made, whether they can be repaid and what are considered ineligible hardship distributions. Becoming familiar with recent IRS guidance will ensure compliance with regulations. To help clients, prospects, and others, Wilson Lewis has provided a summary of the key details below.

What are Hardship Distributions?

These are withdrawals participants can make from retirement plans before they reach retirement age if they are experiencing a financial emergency. These extreme need scenarios might include covering medical expenses, paying for funeral costs, or preventing foreclosure or eviction from a home. Taxpayers are subject to specific limitations and criteria to qualify the financial emergency before distributions are awarded. Distributions are also limited to designated amounts and can come with tax consequences, including income tax and, potentially, penalties.

Are Plans Required to Provide Hardship Distributions?

Many plans that allow for elective deferrals offer hardship distributions, including 401(k), 403(b), and 457(b) plans. However, it’s not mandatory for these plans to do so

What is the Eligibility Criteria?  

The criteria that’s eligible for hardship distributions will vary based on the language of the plan. For example, some plans may make distributions for medical emergencies, but not for tuition payments, while other plans may allow for both scenarios and more. These situations need to be clearly outlined in the plan language so there is a standard and unbiased criteria to determine hardship eligibility.

The rules between plans are fairly similar. 403(b) plans are similar to 401(k) plans in their rules for hardship distributions. 457(b) plans require specific language addressing what is considered an “unforeseeable emergency” that would lead to hardship distributions.

What is a Hardship?

The IRS defines hardship as an event that gives rise to an “immediate and heavy financial need” for the employee. The amount of the distribution needs to be sufficient to cover the financial need as part of the hardship. Employee needs during a hardship also extend to spouses, dependents, and potentially other primary beneficiaries who may incur “qualifying medical, educational, and funeral expenses.”

Some events that are considered “immediate and heavy” by the IRS include:

• Costs associated with buying a principal residence
• Funeral expenses
• Certain medical costs
• Educational fees and tuition expenses
• Payments associated with preventing eviction and foreclosure
• Costs for repairing damage to a principal residence that qualify under IRC Section 165
• Expenses and losses related to a federal disaster declaration for residences and places of employment

What is an Ineligible Hardship?

Conversely, if there isn’t a heavy and immediate financial need to be fulfilled by a distribution, it wouldn’t be considered necessary per the IRS definition. If the employee can access other resources to cover the need, extending to assets belonging to the spouse and minor children, this would not be cause for an eligible hardship distribution.

Available resources could include things like vacation homes but are not likely to include irrevocable trusts for children, for example.

Even if a need was immediate or heavy, if it is reasonable that the employee could have foreseen the problem, or if the individual voluntarily took on the burden, these expenses may not qualify. Recreational purchases, for example, don’t generally apply for hardship distributions.

Distributions may be limited if the taxpayer hasn’t yet received other available plan distributions. Plan administrators may also require employees to take out a plan loan before receiving a hardship distribution.

The amount is limited by what is necessary to cover the financial hardship, which could include associated taxes and penalties.

Employees should demonstrate that they are experiencing an eligible hardship that cannot be relieved using other resources. However, if an employer has “actual knowledge” that the need can be relieved using actual resources, relying on the employee’s representation of the situation is not sufficient. Regardless, employees aren’t required to take counterproductive actions that would further harm their financial situation, such as taking out a plan loan that could prevent them from necessary financing for a home purchase.

Contact Us

The rules and regulations surrounding hardship distributions can be complicated. For this reason it may be necessary to consult with a qualified professional to determine your best path forward. If you have questions about the information outlined above or need assistance with your next retirement plan audit, Wilson Lewis can help. For additional information call 770-476-1004 or click here to contact us. We look forward to speaking with you soon.