Qualified Deferred Compensation Plans Under 401(k), 403(b) and 457(b)
The rules for hardship distributions vary by the type of plan from which you intend to take a hardship withdrawal. What constitutes a “hardship” is typically set forth in the plan itself. If your 401(k), 403(b) and 457(b) plan permits hardship withdrawals, for example, the plan may permit distributions for medical or funeral expenses, but not for the purchase of a principal residence or for payment of tuition and education expenses.
What is the IRS definition of “hardship”?
While similar, the specific tests for hardship withdrawals vary slightly according to the type of plan. A hardship distribution from a 401(k) plan, for example, depends on an “immediate and heavy financial need of the employee” and/ or the employee’s family (See Reg. §1.401(k)-1(d)(3)(i))). Under the provisions of the Pension Protection Act of 2006, the need of the employee also may also include the need of the employee’s non-spouse, non-dependent beneficiary. The amount of the distribution may not exceed the amount of the need, however, the distribution may include funds necessary to cover any taxes or penalties that may result from the distribution. (Reg. §1.401(k)-1(d)(3)(iv)(A)). The rules for hardship distributions from 403(b) plans are similar to those for hardship distributions from 401(k) plans.
Whether a need is immediate and heavy depends on the facts and circumstances. Certain expenses are deemed to be immediate and heavy, including: (1) certain medical expenses; (2) costs relating to the purchase of a principal residence; (3) tuition and related educational fees and expenses; (4) payments necessary to prevent eviction from, or foreclosure on, a principal residence; (5) burial or funeral expenses; and (6) certain expenses for the repair of damage to the employee’s principal residence. Expenses for the purchase of consumer goods such as a boat or television would generally not qualify for a hardship distribution. A financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee. (Reg. §1.401(k)-1(d)(3)(iii)). If your hardship distribution is from a 457(b) plan, in contrast, you must be able to show “unforeseeable emergency.” (Reg. § 1.457-6(c)(2))
A distribution is not considered necessary to satisfy an immediate and heavy financial need of an employee if the employee has other resources available to meet the need, including assets of the employee’s spouse and minor children. Whether other resources are available is determined based on facts and circumstances. Thus, for example, a vacation home owned by the employee and the employee’s spouse generally is considered a resource of the employee, while property held for the employee’s child under an irrevocable trust or under the Uniform Gifts to Minors Act is not considered a resource of the employee. (Reg. §1.401(k)-1(d)(3)(iv)(B))
What Do I Need To Provide In Order To Prove I Have An Immediate And Heavy Financial Need?
Most 401(k) plans follow “deemed necessary” rules, which in plain terms means it is not necessary to provide personal financial information to your employer or plan administrator to prove hardship. Generally, if a 401(k) plan provides for hardship distributions, the plan will specify what information must be provided to the employer to demonstrate a hardship. An employer may generally rely on the employee’s representation that he or she is experiencing an immediate and heavy financial need that cannot be relieved from other resources, unless the employer is actually aware that the employee can meet his immediate need:
(1) Through reimbursement or compensation by insurance;
(2) By liquidation of the employee’s assets;
(3) By stopping elective contributions or employee contributions under the plan;
(4) By other currently available distributions (such as plan loans) under plans maintained by the employer or by any other employer; or
(5) By borrowing from commercial sources. (Reg. §1.401(k)-1(d)(3)(iv)(C))
What is the maximum amount that can be distributed as a hardship from a 401(k) plan?
The amount allowable as a hardship distribution cannot be more than your total elective contributions – including Roth contributions – as of the date of the withdrawal, less any prior elective distributions you’ve taken for prior hardships or other reasons. This is referred to as the “maximum distributable amount”. This amount generally does not include earnings, non-elective contributions (such as required minimum distributions) or matching contributions. Other amounts under the plan, if any, such as your employer’s matching contributions and discretionary profit-sharing contributions may also be distributed on account of hardship if the plan so provides. (Reg. §1.401(k)-1(d)(3)(ii)).
What are the tax consequences of taking a hardship distribution from a 401(k) plan?
After an employee receives a hardship distribution of elective contributions from his or her 401(k) plan, generally the employee will be prohibited from making elective contributions and employee contributions to the plan and all other plans maintained by the employer for at least 6 months after receipt of the hardship distribution.
Hardship distributions are includible in gross income unless they consist of designated Roth contributions. In addition, they may be subject to an additional tax on early distributions of elective contributions. Unlike loans, hardship distributions are not repaid to the plan. Hardship distributions permanently reduce the employee’s account balance under the plan.
A hardship distribution cannot be rolled over into an IRA or another qualified plan. (Code § 402(c)(4))
What is a distribution on account of an “unforeseeable emergency” under a 457(b) plan?
Unlike 401(k) and 403(b) plans, a hardship distribution under a 457(b) plan can only occur when the participant is faced with an unforeseeable emergency. (Code § 457(d)(1)(iii)). An unforeseeable emergency is a severe financial hardship resulting from an illness or accident, loss of property due to casualty, or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant or beneficiary. Examples include imminent foreclosure on, or eviction from, the employee’s home, medical expenses, and funeral expenses. Generally, the purchase of a home and the payment of college tuition are not unforeseeable emergencies.
(Reg. § 1.457-6(c)(2)(i))
Whether a participant or beneficiary is faced with an unforeseeable emergency depends on the facts and circumstances. However, a distribution is not considered an unforeseeable emergency to the extent that the emergency can be relieved through insurance, liquidation of the participant’s assets, or cessation of deferrals under the plan. (Reg. § 1.457-6(c)(2)(ii)). A distribution on account of an unforeseeable emergency must not exceed the amount reasonably necessary to satisfy the emergency need. (Reg. § 1.457-6(c)(2)(iii))
Are hardship distributions allowed from IRAs?
There is generally no limit on whether or when an IRA owner may take a distribution from his or her IRA. There may, however, be considerable tax consequences from taking an “early distribution” absent a hardship. The rules defining “hardship” for IRA withdrawals are similar to those pertaining to qualified retirement plans. If qualified, hardship distributions from IRAs and Roth IRAs will be exempt from the additional tax.
Certain other types of withdrawals from an IRA account would not subject you to the extra tax. These include withdrawals for higher education expenses or to finance a first-time home purchase. (Code § 72(t)(2)(E),(F))