Posted by Maria T. Hurd, CPA
State or local governments and organizations that are tax-exempt under IRC Section 501(c) can establish a 457(b) plan to allow their employees to defer income taxation on retirement savings, similar to how the more popular 401(k) plans operate, but with some important differences, including the availability of hardship distributions.
Unlike hardship distributions from 401(k) and 403(b) plans, hardship distributions from 457(b) plans may not be made for the acquisition of a principal residence or for the payment of tuition and related educational fees. In the case of 457(b) plans, unforeseeable emergencies must be defined in the plan document as a severe financial hardship of the participant or beneficiary resulting from:
- an illness or accident of the participant or beneficiary, the participant’s or beneficiary’s spouse, or the participant’s or beneficiary’s dependent (as defined in IRC section 152(a);
- loss of the participant’s or beneficiary’s property due to casualty (including the need to rebuild a home following damage to a home not otherwise covered by homeowner’s insurance);
- funeral expenses of a spouse or dependent (as defined in IRC section 152(a);)
- or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant or the beneficiary (including imminent foreclosure or eviction from a primary residence, or to pay for medical expenses or prescription drug medications).
Revenue Ruling 2010-27 contains examples of certain expenses that may be eligible for an unforeseeable emergency distribution from a 457(b) deferred compensation plan. This ruling determines that residential flood damage or funeral expenses of a non-dependent child may be considered an unforeseeable emergency arising from events beyond the control of the participant. However, accumulated credit card debt would not be eligible for an unforeseeable emergency distribution. Although the Final Regulations only list funeral expenses of a spouse or a dependent as qualifying expenses, the Revenue Ruling explains that the funeral expenses of a non-dependent adult child is an extraordinary and unforeseeable circumstance that arises as a result of events beyond the control of the participant and is substantially similar to the need to pay for the funeral expenses of a dependent. These examples can be found on the IRS website.
A distribution due to an unforeseeable emergency must be limited to the amount reasonably necessary to satisfy the emergency need, including any amount necessary to pay federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution. However, the participant may elect out of tax withholding, since hardship distributions are not eligible for rollover. Finally, the participant seeking the distribution must show that the emergency expenses could not otherwise be covered by insurance, liquidation of the participant’s assets, or cessation of deferrals under the plan.
Plan sponsors must know the hardship rules and ensure that proper documentation is obtained to substantiate both the amount and the reason for approved hardship distributions. Operational errors in this area are common, and usually the result of plan sponsor’s ignorance of the rules regarding what constitutes a hardship, or an incorrect assumption that the third party administrator will collect the necessary backup.