It’s 4 p.m. on a Friday, and there’s a knock on the door of the human resource manager’s office. It’s Zachary, a fairly new employee who entered the company’s 401(k) plan last month. He’s been deferring $40 a week into the plan, which means he has accumulated $160 by now. Last night, his cable TV was shut off because he couldn’t afford to pay the bill, and, from his 23-year-old point of view, retirement seems like a long way off.

He explained his situation to the HR manager and asked if he could get his deferrals back so he could reconnect the cable. After all, it was his money. The HR manager explained that, under the terms of the plan, the only type of distribution available to someone younger than 59½ who is still employed is a hardship distribution. Zachary’s eyes lit up. “Yeah, a hardship distribution,” he repeated. “That’s what I want.”

For this young man, living even one day without cable TV seemed like a perfect example of a “hardship.” However, the Internal Revenue Code has a different interpretation. Here is a close-up look at the rules concerning hardship distributions.

A defined contribution plan is not required to provide for in-service distributions in the event of hardship. To permit hardship distributions, appropriate language must be contained in the plan document. The type of retirement plan most likely to offer hardship distributions is the ever-popular 401(k) plan, funded primarily by employee salary deferrals.

Because these accounts are funded by employees’ own contributions, many employers feel an obligation to make them available in times of need. It provides a feeling of security that may encourage participation which can, in turn, help increase allowable deferral limits for highly compensated employees. However, hardship is the only allowable reason for an in-service distribution from salary deferral accounts prior to age 59½.

Many profit sharing plans do not contain hardship provisions for employer-funded accounts such as matching and profit sharing contributions. If the employer chooses to allow hardship distributions from employer-funded accounts, it has the discretion as to how hardships are defined, unlike salary deferral distributions which are subject to restrictive IRS requirements. In order to simplify plan administration, some plan documents also apply the more restrictive salary deferral hardship withdrawal requirements to hardship withdrawals from employer-funded accounts.

Even if a participant can demonstrate an immediate and heavy financial need, the participant must show that the need can only be satisfied by a withdrawal from his or her salary deferral account and that the need cannot be satisfied by other sources that are reasonably available to the participant. Unless the plan sponsor has actual knowledge to the contrary, the plan sponsor may rely on the participant’s written statement that the need cannot be relieved from other available resources including:

• Reimbursement or compensation by insurance or otherwise
• Liquidation of the participant’s assets
• Cessation of elective or other employee contributions to the plan
• Other currently available distributions and loans from plans maintained by any employer
• Borrowing from commercial sources on reasonable terms

Any of the sources listed above will not be considered an available source if it results in an increase in the amount of the financial need. A plan can choose to utilize a safe harbor test in which case the distribution will be deemed necessary to satisfy the need if the following requirements are met:

• The participant has obtained all other currently available distributions and loans from all plans maintained by the employer, and the participant is prohibited from making elective and other employee contributions to any plan maintained by the employer for at least six months after receipt of the hardship distribution (this suspension rule does not apply to mandatory employee contributions to a defined benefit plan or to a health or welfare benefit plan)
• Cessation of elective or other employee contributions to the plan
• Other currently available distributions and loans from plans maintained by any employer
• Borrowing from commercial sources on reasonable terms

Plan sponsors may be confused by the requirement that all available plan loans must be taken before becoming eligible for a hardship distribution. After all, if the plan allows for loans, how can you justify approving the hardship distribution without first requiring that the loan be taken? The IRS regulations provide that any available loan not serve to merely increase the extent of the financial hardship.

In many situations, the burden of loan repayments and additional debt on the participant’s credit report could worsen the participant’s financial situation. For example, the additional debt of a plan loan could disqualify a participant from obtaining the mortgage needed to purchase a home.

Different rules apply depending upon the source of funds being withdrawn.

Only the accumulated employee deferrals may be distributed; investment earnings may not be distributed except for certain earnings accumulated in the plan prior to 1989.

The plan may permit the entire vested employer-funded account balance to be distributed, including earnings. Employer qualified non-elective contributions (QNECs) and qualified matching contributions (QMACs) made for purposes of passing nondiscrimination testing may not be distributed as in-service distributions unless the employee has attained age 59½ (an exception applies for QNECs and QMACs credited prior to 1989). Also, employer safe harbor 401(k) contributions may not be distributed.

The IRS expects the plan sponsor to require proof of financial need before authorizing a hardship distribution from the plan. Simply relying on the reason checked on the hardship request is not enough. Proof may include copies of medical bills and insurance statements, past due notices from the landlord or mortgage company, copies of college tuition bills, etc.

The ability to request hardship distributions electronically is growing in popularity. During this process, participants self-certify that they meet the hardship criteria. The IRS has made it clear that electronic self- certification does not relieve the plan sponsor of the need to gather documentation of the immediate and heavy financial need.

It is important that the plan sponsor retains a record of all information used to determine whether a participant was eligible for a hardship distribution and the amount distributed was the amount necessary to alleviate the hardship. If the plan is audited by the IRS, the agent will look for this documentation.

Hardship distributions are taxable in the year received and are included in gross income unless they consist of designated Roth contributions. In addition, they may be subject to an additional 10 percent early withdrawal penalty if the participant has not reached age 59½. Hardship distributions are not eligible for rollover to an IRA or another qualified plan and may not be repaid to the plan.

Hardship distributions are a valuable component of many 401(k) plans. They encourage participation in the plan and provide a sense of security to participants as they seek a balance between retirement savings and current financial needs.

Authorizing plan distributions that do not satisfy the IRS hardship requirements can result in plan disqualification and adverse tax consequences for the participants and the plan sponsor. Therefore, it is important plan sponsors understand the hardship distribution requirements and make sure their hardship distribution paperwork is in order.