Unexpected emergencies can come up at any time, and when they do, your employees may need to take a 401(k) hardship withdrawal for any financial gaps not covered by their paycheck.
The problem is, managing hardship distributions for employees can be an administrative nightmare without the proper procedures in place. Prepare for these situations beforehand to ensure smooth sailing for you and your employees when the time comes.
What is a 401(k) hardship withdrawal?
Q: Small Business 401(k) Plans: What to Know as an EmployerTeam Management
Also known as a hardship distribution, a 401(k) hardship withdrawal is an optional benefit that’s often offered by employers. They’re similar to early withdrawals in that they can be taken from an employer-sponsored retirement fund before the age of 59.5.
But while early withdrawals refer to any distribution taken before age 59.5, hardship withdrawals are taken specifically to cover an “immediate and heavy financial need” according to the IRS. They come with specific qualifications that must be met (more on this below), and even then, they’re only approved at the plan provider’s discretion.
One important thing to note is that the amount a plan participant takes under a 401(k) hardship withdrawal could be subject to a hefty fee—namely, a 10 percent withdrawal penalty if the employee is under 59.5 years old—and that’s in addition to any applicable taxes. Participants may be able to avoid paying the 10 percent penalty if they’re in one of the following situations:
- They become totally and permanently disabled
- They have qualifying medical debt that exceeds 7.5% of their adjusted gross income
- They are required by court order to give the money to a divorced spouse, child, or dependent
401(k) hardship withdrawal rules and limitations
Safe harbor distributions
If a plan participant withdraws funds for one of the following reasons, they’re known as “safe harbor” distributions and are automatically considered an “immediate and heavy financial need” in the eyes of the IRS:
- Certain medical care expenses, such as medical procedures or treatments for the employee, spouse, or dependents
- Costs related to the purchase of an employee’s principal residence (except mortgage payments)
- Tuition, room and board, and other related educational expenses and fees for the next 12 months for the employee, spouse, dependents, or children who are no longer dependents
- Payments necessary to prevent eviction from or foreclosure on an employee’s principal residence
- Funeral or burial expenses for the employee’s spouse, dependent, child who is no longer a dependent—or for the employee
- Certain expenses to repair sudden, unexpected, or unusual damage to an employee’s principal residence
- Expenses, including loss of income, incurred from living in a FEMA-designated disaster area
Other requirements and limitations to remember
When applying for a 401(k) hardship distribution, employees must prove that they’ve exhausted all other possible funds and that they’re only taking the exact amount they need. However, participants can increase this amount to cover any tax and penalty deductions on their distribution.
There are no definite limits on the number of hardship withdrawals an employee can take in a year, but they’ll be limited to whether they’ll be approved for one and whether their 401(k) has enough money to cover the withdrawal. Also, some 401(k) plans may have even stricter guidelines than the IRS. This means that even if any employee has a qualifying hardship as defined by the IRS, if it doesn’t meet their plan rules, then their hardship withdrawal request will be denied.
Combine this information with the fact that participants aren’t allowed to pay back the money they take through a hardship withdrawal, and it’s easy to see why most financial experts recommend avoiding this option if possible. (Don’t worry, we’ll break it down in the next section too.)
Note that this is not an exhaustive list of guidelines and limitations—plan providers may choose to add more to the IRS’s own requirements. Because each plan will have its own set of rules, employees in need of a hardship withdrawal should check with their benefits administrator or 401(k) plan document for more specifics.
Taking hardship withdrawals from old 401(k) accounts
Are hardship withdrawals limited to current employees with active employer-sponsored plans only? It depends on your 401(k) plan rules. You learned earlier that not all 401(k) plans offer hardship withdrawals. Similarly, your plan may not allow terminated employees to take hardship distributions either.
The drawbacks of taking a 401(k) hardship withdrawal
In addition to the sting of a possible 10 percent penalty, an employee can’t return the amount taken through a hardship distribution—even if they have the resources to do so. This is because of the annual contribution limit imposed on these retirement plans.
Say an employee needs to withdraw $50,000 from their account. The contribution limit for the 2021 tax year is $19,500, and if they’re over the age of 50, they’re allowed to contribute an additional $6,500 for a total of $26,000 a year.
At this rate, even if one were to max out their 401(k) contributions for the year, it would still take an employee over the age of 50 two years to replace those funds—and three years for someone younger than 50.
On top of that, employees who take a hardship withdrawal may sell their investments in a down market and/or miss out on the benefits of compounding interest. When funds are withdrawn, the employee loses out on their potential future earnings.
Educate your employees on these drawbacks and encourage them to look at other options—like a traditional loan or 401(k) loans, if you offer them—before they commit to a hardship distribution.
What the 401(k) hardship distribution process looks like
- You (or the plan administrator) provide the employee with the appropriate paperwork to fill out.
- They submit their request, along with the proper documentation.
- The plan administrator reviews the plan document and the employee’s hardship distribution forms, along with any supporting documents, to ensure their request follows the plan rules for hardship withdrawals.
- If the application is approved, the employee will receive the money they requested.
The process may take a few weeks from start to finish, but ultimately it varies by plan. Employees should continue contributing to their 401(k) account and maximize their contributions as soon as possible after the withdrawal.
For more details on the review process, check out these hardship distribution do’s and don’ts.
How to document 401(k) hardship distributions
The qualifications for a 401(k) hardship withdrawal seem easy to grasp in theory, but they’re surprisingly tricky to navigate in real life. Take care in assessing each request, as employees may try to stretch the rules to fit their needs.
The IRS states that the “plan administrator must have enough information to adjudicate the claim,” which basically means that your employees must show adequate proof of hardship for their request to be approved.Their word alone won’t be good enough if the IRS decides to conduct an audit.
The problem is, the agency doesn’t define what proof you’ll need. This means you’ll need to use your best judgment. As every situation is different, the documents you’ll need will vary too.
If an employee plans to withdraw funds for medical expenses, for example, their source documents should include what the medical care was for, the name and address of their care provider, the exact amount in medical expenses that wasn’t covered by their insurance, plus any other documents they may need to justify their request.
Expect to collect some form of the following for every hardship distribution application:
- Documentation of the hardship request, including your own review or approval
- Documentation to support the employee’s financial need
- Documentation to show that the withdrawal followed the plan’s rules and IRS regulations
- Proof that the payment was made to the employee and reported on Form 1099-R
What makes a 401(k) loan different from a hardship withdrawal?
There are no IRS regulations on what 401(k) loans can be used for, so they can be put toward a wider variety of purposes than hardship withdrawals can.
When you take out one of these loans, you don’t pay taxes on the amount if you meet certain criteria. And because it doesn’t count as a withdrawal, you don’t pay the 10% early withdrawal penalty either.
There are limits, though, on the withdrawal amount. The IRS states that hardship withdrawals are limited to the lesser of 50% of an employee’s 401(k) account balance and $50,000.
Under typical circumstances, 401(k) loans must be paid back into the participant’s account with interest over five years, although this timeline can be extended if the funds are used to buy a home. If the loan is not paid in full by the due date, the IRS treats the remaining debt as a withdrawal.
401(k) hardship distribution FAQs for employers
This can be a complex topic, so here are some commonly asked questions posed by employers.
Where should I keep information on 401(k) hardship withdrawals for my employees?
All information on 401(k) plans and hardship distributions should be given directly to employees, and should be included in the employee handbook as well.
You’ll want to include details such as:
- The plan’s definition of a hardship
- The procedures employees must follow to request a hardship distribution
- Information employees should provide to properly document their request
- Other frequently asked questions related to this benefit
Keep in mind that new legislation can change the rules and guidelines surrounding 401(k) hardship withdrawals, as they did in 2018 and 2020.
Schedule check-ins with your benefits advisor a few months before the start of every plan year to determine if any changes are needed, then update your 401(k) plan guidelines and send updates to all plan participants accordingly.
Why is it important to maintain proper documentation for 401(k) hardship distributions?
It’s up to your organization to ensure that plan procedures are followed and proper documentation is kept—and yes, even if you outsource your benefits administration or HR.
Collect and store your employees’ paperwork as they go through the distribution process so you have it on hand should the IRS conduct an audit. If you outsource your benefits administration, confirm that the company follows your plan guidelines and ensure that you have access to the documentation at any time.
If the IRS conducts an audit and finds out that you’re not maintaining proper documentation, it can disqualify your company’s retirement plan and terminate your organization’s tax-favored status. Essentially, this means that any contributions you make to your employees’ plans will not be tax-deductible and employees will be taxed on their contributions as well.
What happens if I make a hardship distribution but my plan doesn’t have language permitting them?
Employers cannot make a 401(k) hardship distribution if their plan document doesn’t include language allowing it. If a distribution is made, you can update your plan retroactively using the IRS’s plan amendment correction method.
What happens if a hardship distribution isn’t made according to the 401(k) plan document?
Sometimes, a plan may only allow for hardship distributions under specific circumstances. If an employee makes a non-permitted withdrawal, they must return any money they received through the hardship distribution plus earnings on that amount. Of course, this may be difficult to do if the employee has already spent the distribution funds.
The IRS states that the method of correction will depend on the circumstances of each situation, but that it may involve paybacks, employer corrective contributions, and plan amendments. You’ll want to submit a Voluntary Correction Program (VCP) application and work with your IRS agent to figure out the best way to correct this mistake.
What happens if any other mistakes are made during the distribution process?
Because 401(k) plans are fraught with rules and regulations, plan errors are bound to happen. That’s why the IRS has dedicated an entire page to helping employers through the error correction process.
If you come across any mistakes, you’ll want to correct them as soon as possible through the IRS website. Otherwise, if the IRS discovers it during an audit, they may disqualify your plan and you’ll lose all of the associated tax benefits. You’ll then need to correct the errors before the agency will reinstate your plan.
You can find solutions to other common 401(k) plan mistakes on the IRS website.
When times are hard, it’s easy to abandon future benefits for immediate relief. But because of the risks involved with 401(k) hardship withdrawals, this option should really only be considered in a dire financial emergency.
Whenever possible, advise your employees to explore alternatives for their situation with a financial advisor.