Hardship distributions can be a lifeline for cash-strapped retirement plan participants, but can backfire on plan sponsors if errors in their operation aren’t corrected promptly.
Updated documents posted by the IRS on its website in September raised the specter of the plan losing its qualified status under the tax code in that scenario.
“To preserve the tax qualified status of the plan, the sponsor should correct these errors right away,” the agency said in one document of the three it posted on its website.
This document listed three common errors in hardship distributions, all involving the sponsor’s failure to follow the terms of the plan. For example, the plan might make hardship distributions even though the plan doesn’t allow them, the IRS said.
Doing so is an operational error that may be corrected through a retroactive amendment to the plan, the IRS said.
Such an amendment must satisfy the tax code section 401(a) qualification requirements, the agency said in a second document.
In addition, the plan as amended must have satisfied those qualification requirements had the amendment been adopted when the hardship distributions were first made available, including if applicable the hardship distribution requirements under Section 401(k), it said.
A second common error occurs when the plan language allows hardship distributions under specified circumstances only, but the plan is “more liberal in its operation” by allowing hardship distributions for other reasons, the IRS said. For example, the plan can’t allow a hardship distribution for a home purchase if the plan document limits hardship distributions to paying tuition. Likewise, it can’t distribute funds for funeral expenses “unless it specifically lists these expenses as a stated reason for a hardship.”
To correct this error, the plan sponsor should prospectively amend the plan, the IRS said.
Suspending Salary Deferrals
A third common error occurs when the plan fails to suspend participant salary deferrals to the plan and all other employer plans for at least six months after the participant receives a hardship distribution, even though the suspension is required under the plan document.
In general, IRS rules prohibit the employee from making elective contributions and employee contributions to the plan and all other plans maintained by the employer for at least six months after receipt of the hardship distribution.
The IRS identified two possible corrections for this failure. One is to suspend the employee from making salary deferrals for a six-month period going forward.
A second approach is to require the participant to return the hardship distribution, adjusted for earnings, to the plan.
But neither correction option may be fully satisfactory, the IRS said. The first correction might not put the participant in the same position he or she would have been in had the plan suspended the contributions immediately after receiving the hardship distribution.
The second approach could put the participant in the same position he or she would have been in had the failure not occurred, but “may not be a viable solution because the affected employee may not have sufficient resources to repay a hardship distribution,” the IRS said.
When Hardship Distributions Are Permitted
Plan sponsors uncertain about when hardship distributions are allowed might want to consult a third document that the IRS posted as part of this series on hardship distributions.
In that third document, the agency reminded plan sponsors that hardship distributions are allowed from a participant’s elective deferral account if the distribution is due to an immediate and heavy financial need and limited to the amount necessary to satisfy that need.
In general, in a Section 401(k) plan, hardship distributions are allowed only from elective deferrals (not from earnings on those deferrals), employer profit-sharing contributions and regular matching contributions, the agency said.
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