NEWSLETTERS

What Qualifies as a Hardship Distribution?

Hardly a week goes by that I don’t get a call from a plan sponsor making inquires into the rules regarding hardship distributions.

The only circumstance in which a distribution may be made to an active employee before age 59½, is a hardship. The exception is a plan termination or the sale of the assets of a trade, business, or subsidiary. However, if the plan so provides, participants may receive a portion of their vested benefits as plan loans.

For a distribution to qualify as a hardship, two tests must be passed:

• The participant must have an immediate and heavy financial need;

• The distribution must be necessary to meet the need.

The following expenses are deemed to constitute immediate and heavy financial needs.

• Medical expenses;

• Purchase, excluding mortgage payments, of a principal residence for the employee;

• Payment of tuition for post-secondary education for the employee, spouse, or children;

• Payment of amounts needed to prevent the eviction of the employee from a principal residence or foreclosure on the mortgage on the employee’s principal residence.

A hardship distribution may not be made if the employee has other resources available to meet the financial need, even if the need is immediate and heavy. Thus, an employee may have to secure the needed funds elsewhere by liquidating other assets, reimbursement, or borrowing of funds from commercial sources.

A plan may provide that an employee will be deemed to lack other resources reasonably available to meet a financial need, including a deemed financial need, if:

• The employee has obtained all distributions, other than hardship distributions, and all non-taxable loans available under all plans maintained by the employer;

• The plan, and all other plans maintained by the employer, provide that the employee’s elective deferrals and contributions will be suspended for at least 12 months after receipt of the hardship distribution;

• The plan, and all other plans maintained by the employer, provide that the maximum amount of elective contributions that the employee may make for the taxable year, after the year in which the employee received the hardship distribution, is the excess of the annual dollar limit on elective deferrals over the amount of the employee’s elective deferrals for the year the hardship distribution was received.

In addition to being subject to regular income tax, most hardship distributions are subject to an additional 10 percent tax on early distributions from qualified plans.

The only exception to the 10 percent tax that usually applies, is expenses not exceeding the allowable deduction for medical expenses. Medical expenses are deductible only to the extent that they exceed 7.5 percent of adjusted gross income. Most hardship distributions made to cover medical expenses are likely to be subject in part to the 10 percent additional tax.

These are not eligible for rollover, effective for distributions made after December 31, 1998. However, the IRS provided transition relief in Notice 99-5 for distributions occurring before January 1, 2000. Distributions made during the calendar year 1999 can be treated as an eligible rollover distribution as long as it would have been one prior to December 31, 1998.

Because 401(k) plan hardship distributions potentially are subject to income tax and the 10 percent tax on early withdrawals (unless an exception applies), some participants have taken a hardship withdrawal from their 401(k) plan account and, to avoid the early withdrawal tax, rolled the money into an IRA then into a Roth IRA before withdrawing the money.

Since the money was taxed when it was rolled over into the Roth IRA, it will not be taxed again when it’s distributed from the Roth IRA. After 1998, this approach is no longer effective.

In addition, effective 1999, 401(k) plan hardship distributions are no longer subject to the 20 percent mandatory withholding rules since they are no longer eligible for rollover.

Hardship distributions may be made only from the amount of an employee’s elective deferrals, not from amounts attributable to investment earnings on those contributions. Non-elective employer contributions that are combined with elective deferrals to meet the 1.25 or 2.0 tests, and any income on those deferrals, may not be distributed on account of hardship.

Hardship distributions can present a variety of issues. Plan sponsors should be familiar with these rules and refer to their plan document and summary plan description when processing hardship distributions.

© Administrative Retirement Services, Inc.  2000
Published by Administrative Retirement Services, Inc., Copyright 2001 by Administrative Retirement Services, Inc. Reproduction in whole or in part is prohibited except by written permission. All rights are reserved.  Information has been obtained by Administrative Retirement Services, Inc. from sources believed to be reliable. However, because of the possibility of human or mechanical error by our sources, Administrative Retirement Services, Inc. or others, Administrative Retirement Services, Inc. does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions or the result obtained from the use of such information.  Readers should seek specific advice before acting with regard to the subjects mentioned here.

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