Posted by Maria T. Hurd, CPA
Administering hardship distributions correctly is important to prevent the hardship of completing a correction of an error in administration. Often, plan officials assume that their third party administrator is collecting all the information necessary for the approval and proper processing of a hardship, when that is not always the case. When mistakes happen, plan sponsors should refer to the 401(k) Plan Fix-It-Guide posted on the IRS website to educate themselves regarding possible corrections through the Self-Correction Program (SCP), the Voluntary Compliance Program (VCP) application, a submission for which there is a standard fee based on the number of participants or, in the event the error gets caught as a result of an IRS audit, the Audit CAP, which allows the sponsor to correct the mistake and pay a negotiated sanction. An employer’s eligibility for each of the available programs is discussed in detail on Revenue Procedure 2013-12.
To avoid the hardship of correcting a hardship distribution mistake, plan sponsors should be well aware of the rules regarding:
a) Hardship definition
b) Amount of the distribution
c) Eligibility for a distribution
d) Backup needed and who is responsible for obtaining it
In 401(k) and 403(b) plans that permit hardship distributions, the employer can determine whether an employee has an immediate and heavy financial need based on all relevant facts and circumstances. However, most plans reference the Internal Revenue Code’s definition of a hardship, which includes:
- Medical care expenses for the employee, the employee’s spouse or any dependents of the employee;
- Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);
- Payment of tuition, related educational fees, and room and board expenses for the next 12 months of post-secondary education for the employee, the employee’s spouse, children or dependents;
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or mortgage foreclosure on that residence;
- Funeral expenses for the employee’s deceased parent, spouse, etc.; or
- Certain expenses relating to the repair of damage to the employee’s principal residence.
Amount of the distribution
The amount of an immediate and heavy financial need may include any amounts necessary to pay any federal, state or local income taxes or penalties that reasonably result from the distribution.
Eligibility for a distribution
An employer may not treat a distribution as necessary to satisfy an immediate and heavy financial need if the financial need may be satisfied from other resources reasonably available to the employee. Employers generally may rely on the employee’s written representation that the financial need cannot be satisfied from other sources, other than ensuring that the participant has taken the maximum participant loan available under the plan.
Plan provisions permitting distributions
Before approving a hardship distribution, employers should ensure that the plan document includes a hardship provision. If an employer makes hardship distributions available to all plan participants, but the plan does not have a hardship provision, an employer can self-correct the operational error by adopting a retroactive plan amendment. Self-correction by retroactive amendment is not an option if the hardship distributions were not made available in a nondiscriminatory manner. In those cases, employers must file a Voluntary Correction Program (VCP) application.
If an employer authorizes hardship distributions that don’t meet the plan’s hardship requirements, makes distributions that exceed the hardship amount, fails to obtain the necessary backup, or fails to ensure that the participant obtained the maximum available participant loan, it is possible that there may not be adequate practices and procedures in place for processing hardship distributions accurately. If controls are not in place, the Self-Correction Program (SCP) is not available to the employer, and a Voluntary Compliance Program (VCP) application should be submitted. Potential corrections that can be proposed or completed include, among others:
- The participant paying back the amount they received plus earnings.
- Employer contributions
- Retroactive plan amendments
- Obtaining the necessary backup
Preventing the mistake
Employers should take steps to ensure that hardship distributions are processed accurately, including:
- Review the plan document language to determine when and under what circumstances the plan can approve a distribution.
- Establish hardship distribution procedures working with your benefits professional to determine if these procedures are sufficient to avoid mistakes.
- Obtain a clear understanding of the plan sponsor’s responsibilities and the third party administrator’s responsibilities with respect to obtaining the necessary backup documentation
- Only allow hardship distributions that meet the plan document and IRC Section 401(k) requirements.