IRS guidance on 401(k) hardship withdrawals clarifies uncertain terrain

The Internal Revenue Service has issued guidance around hardship withdrawals from 401(k) plans that clarify what some observers call otherwise murky rules on hardship distributions.

The guidance came in the form of a memo to IRS employees who audit tax-qualified retirement plans such as 401(k)s on how to conduct an audit of “safe harbor” hardship withdrawals.

The guidelines don’t modify existing law, but indicate the items auditors should focus on in ensuring a plan’s legal requirements are satisfied when participants take a withdrawal, Marcia Wagner, principal at the Wagner Law Group, said.

Some such as David Levine, principal at Groom Law Group, believe the guidance is helpful to employers, advisers and providers such as record keepers and third-party administrators because it lays out proper steps and documentation for hardship withdrawals, where there was confusion prior.

“Before, it was completely uncertain,” Mr. Levine said. “This gives clarity to all providers involved as to what’s an acceptable process and what’s not.”

Hardship withdrawals offer participants a way to tap their retirement savings in 401(k) plans. Unlike a loan from the plan, participants don’t have to pay back funds used for a hardship withdrawal. However, they’re subject to income tax and, if the participant isn’t at least 59 ½ years old, a 10% withdrawal penalty.

Participants must prove a heavy and immediate financial need to tap the money, and that the distribution is necessary to satisfy that need.

Some have criticized them, as well as loans from a 401(k), for contributing to “leakage” from the retirement system and contributing to less retirement savings for people. Which is why Ms. Wagner isn’t surprised the government is trying to tighten up the rules around such distributions.

“I think the government wants to make sure people aren’t using the 401(k) plan as a piggy bank,” she said.

About 84% of 401(k) plans offer hardship withdrawals to participants, according to the Plan Sponsor Council of America. The percentage dips almost 20% for small plans, with between one and 49 participants.

Items qualifying for hardships include expenses related to medical care, purchase of a principal residence, tuition, prevention of eviction from a principal residence, burial or funeral expenses, and repair of damages to a principal residence. The IRS requires verification that a distribution is for one of these items.

The IRS, in its new guidelines, issued Feb. 23, said during a plan audit, the review is to look for copies of “source documents, such as estimates, statements and receipts, regarding the hardship or a “summary,” in paper, electronic format or telephone records, of the information contained in the source documents, said Ilene Ferenczy, managing partner at Ferenczy Benefits Law Center.

If there’s a summary, the plan sponsor must give the participant requesting a hardship a statement telling the participant to keep the source documents and provide them on request to the plan sponsor or the plan administrator; the statement details what the participant has to keep, Ms. Ferenczy said.

“Many people have thought historically, and at least one financial institution created a system for approving hardships based on this belief, that a participant need not ‘prove’ with receipts, etc. that he/she experienced one of these events; all that was needed was to have the participant attest that the event had occurred,” Ms. Ferenczy said.

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