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401(k) Hardship Withdrawal: What's Your Plan's Policy?

Ben Werdmuller
February 20, 2018
401(k) Hardship Withdrawal: What's Your Plan's Policy?
Table of contents

Plans sponsors have a lot of options when designing the company’s 401(k) plan. Among the choices an employer can make is whether or not to allow hardship withdrawals. A hardship withdrawal is a distribution taken by a participant before age 59 ½ due to a financial emergency.

401(k) hardship withdrawals are a specific kind of distribution and are governed by various IRS rules. The most important of these, at least for those seeking the withdrawal, is that a 10% penalty applies in most cases, in addition to taxes on the withdrawal.

An option, not a requirement

It is common for plan sponsors to allow hardship withdrawals, but is by no means required. If hardship withdrawals are allowed, the plan documents define the circumstances that permit them. That means defining what exactly constitutes a hardship, and deciding whether to impose other requirements – such as limiting withdrawals to accumulated employee contributions or to a maximum dollar amount.

What counts as “hardship”?

The IRS has something to say about the circumstances under which an employee can request a hardship withdrawal. First, hardship withdrawals are allowed only when a participant has an immediate and heavy financial need. And second, the withdrawal must be necessary to satisfy that financial need. That is, other resources must not be available to pay for the emergency.

It’s up the employer to determine what is considered an immediate and heavy financial need. But rather than develop their own criteria from scratch, plan sponsors can adopt the IRS definition of an immediate and heavy financial need. This so-called safe harbor adoption includes six kinds of expenses that automatically satisfy the IRS definition. These are:

## **IRS Safe Harbor Definitions of Immediate and Heavy Financial Need**
1. Unreimbursed medical expenses for the participant, spouse, or dependents.
2.Purchase of an employee’s principal residence.
3. Payment of college tuition and related educational costs
4. Payments necessary to prevent eviction or foreclosure on the mortgage of a principal residence.
5. Funeral expenses.
6. Certain expenses for the repair of damage to the employee’s principal residence.

If the employee’s hardship withdrawal request meets one of the above criteria, that need must be verified and documented. That brings us to another advantage of adopting the safe harbor definitions of allowed withdrawals: The IRS has provided guidelines for substantiating any of those six safe harbor requests. That means plan sponsors have an understanding of the documentation the IRS requires to support the case for a hardship withdrawal. This can cut down on the number of documents the plan must retain should it be subject to an audit.

Impact on the plan participant

401(k) hardship withdrawal rules set a high bar for these types of distributions. And for good reason. These withdrawals impose a severe hardship on the participant’s nest egg. The 10% penalty on top of the taxes on the distribution can take a huge bite out of a 401(k) account. But the costs to the employee’s 401(k) continue even after the withdrawal.

IRS rules prevent an employee from making elective contributions to the plan for at least six months after the hardship distribution. The foregone savings further limits potential retirement savings. While the participant can make future contributions after six months, there is no provision for returning the amount withdrawn back into the account.

This negative effect on retirement savings is probably why the IRS requires employees to exhaust all available (nontaxable) 401(k) loans before taking a hardship withdrawal. There is no 10% penalty or tax associated with a 401(k) loan, and the interest goes to the participants own account.  

Penalty-free hardship withdrawals

There are circumstances where participants can take a 401(k) hardship withdrawal without penalty. While the 10% penalty is not imposed on the participant, taxes on the distribution must still be paid:

## **Circumstances Allowed for Penalty Free Hardship Withdrawals**
1.Disability
2.Medical debt exceeds 7.5% of adjusted gross income.
3.A court order requires payment to a divorced spouse, child, or a dependent.
4.Separated from a job in the year you turn 55, or later.
5.Separated from after setting up payment schedule to withdraw money in substantially equal amounts based on life expectancy.

Too busy to deal with 401(k) hardship withdrawals?

As with many aspects of a providing a 401(k) for you and your employees, administering hardship withdrawal requests can be a time-consuming exercise. That’s why ForUsAll handles not only investment management, but also all administrative tasks, including compliance. We offer payroll integration that connects with more than a dozen cloud-based payroll providers, eliminating manual work. ForUsAll provides automated compliance checks that run continuously to proactively fix and correct potential issues. We track employee eligibility and send required participant notices. And we review and process all hardship withdrawal requests.

If you need to spend less time on your company’s 401(k) and more time running your business, don’t hesitate to be in touch today!

Download the 2023 Safe Harbor Guide
Understand new rules for 2023, benefits of Safe Harbor and strategies to minimize Safe Harbor costs.
Ben Werdmuller
About Author -
Ben Werdmuller
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This material has been prepared for informational and educational purposes only and should not be construed as a recommendation by ForUsAll, Inc., its affiliates or employees (collectively, “ForUsAll”)  to activate a cryptocurrency window or invest in crypto.  Investing in crypto can be risky and investors must be able to afford to lose their entire investment.  You should consult with your own advisers before activating a cryptocurrency window or investing in crypto.  ForUsAll does not provide legal, tax, or accounting advice. Please refer to your Plan's fee disclosure for more details.© 2023 ForUsAll, Inc. All rights reserved.
1 Schwab 2022 401(k) Participant Study - Gen Z/Millenial Focus, October 2022.
2 As of 12/31/2022. Employees include both current employees and terminated participants with a balance.
3 "Morgan Stanley At Work: The Value of a Financial Advisor" Morgan Stanley, March 2022.
4 Sarah Britton was a client when she provided this testimonial through an independent third party review website. She received no compensation for her remarks. There are no known conflicts of interest in the provision of her comments related to the services provided.