Typically, participants may only withdraw funds from their retirement savings without incurring a tax penalty in three scenarios: when they retire, at age 59 1/2, or if the plan terminates for some reason. However, some plans allow hardship withdrawals, early distributions that can be taken to relieve a participant’s “immediate and heavy financial need.” These requirement and changes are detailed by Fox Rothschild, a national law firms with 22 offices nationwide.
Participants are usually only eligible for hardship withdrawals if they’ve already exhausted all other available distributions and non-taxable loans provided by their employer’s plan(s). Additionally, they are generally barred from making any deferrals to the plan for at least six months after receiving a distribution.
The regulations allow hardship withdrawals for a variety of circumstances, including specific medical expenses for participants and eligible dependents and beneficiaries; costs related to the purchase of a primary home; tuition and related educational expenses for eligible dependents; payments necessary to prevent eviction from or foreclosure on a primary residence; certain funeral expenses; and repairs for damages to a participant’s principal residence.
Documenting the Hardship
In the past, some plans required detailed documentation to support a participant’s case for a hardship withdrawal, while others were more lenient, permitting participants to “self-certify” their need for a distribution. Collecting detailed documentation can be arduous, and some plan sponsors believe that asking for such intimate details intrudes upon a participant’s privacy.
Earlier this year, the IRS issued a couple of memoranda setting forth guidelines for IRS auditors to follow when evaluating the necessity of hardship withdrawals in 401(k) and 403(b) plans. (Yes, 403(b) sponsors, this applies to you, too.)
The IRS guidance takes some of the pain out of hardship withdrawals. It provides sponsors some flexibility on whether they should require source documents — i.e., written proof the hardship withdrawal is necessary, such as a tuition bill or eviction notice — or summary documentation, i.e, names of those incurring the costs, relationship to the participant, and other specific information, depending on the hardship in question. A full list of the required information can be found here.
Keep in Mind:
The IRS memorandum instructs auditors to carefully scrutinize situations where participants were allowed to receive more than two hardship withdrawals in a single plan year. As such, employers may want to limit the number of hardship withdrawals allowed.
Additionally, for plans permitting summary documentation for hardship withdrawals, consider providing a listing of the required information to participants in advance to ensure they provide necessary and accurate details to support their request.
The bottom line? Participant self-certification is no longer enough to substantiate a hardship withdrawal. As such, plan sponsors should require more detailed information — either source documents or proper summary information as required by the IRS — to avoid plan failure.
