The Pros and Cons of Hardship Distributions to Participants
A hardship distribution allows emergency access to a plan participant’s retirement account balance. Hardship distributions are only allowed for an immediate and heavy financial need, and are limited to the amount necessary to satisfy that financial need. If the Plan Sponsor elects to allow distributions on account of financial hardship, they must meet certain criteria.
Reasons allowed for hardship eligibility in the MVP(k)plan:
- Purchase of primary residence
- To prevent eviction or foreclosure of primary residence
- To pay unreimbursed medical expenses for participant, their spouse, or their dependents
- To pay costs related to post-secondary education for the participant, their spouse or children
- To pay funeral costs for the participant’s spouse or children
- Expenses for the Repair of Damageon the participant’s primary residence that would qualify for the casualtydeduction under IRC §165 (IRS definition)
If the participant can meet one of the above requirements, they will also need to provide documentation which supports the reason for hardship as well as the amount.
The supporting documentation must meet the following criteria:
- The documentation must support the criteria for hardship (as listed above)
- The documentation must be recent (dated at least 30-days from date requesting hardship)
- The documentation must be a bill/invoice – cannot be an explanation of benefits, etc.
- The documentation must show the dollar amount owed
PROS:
- Participants are provided the option to withdraw money from their retirement plan to cover a financial hardship, or to purchase their primary residence or college tuition.
- It is a relatively easy process if the participant’s documentation is in good order.
CONS:
- If the Retirement Plan allows for participant loans, the participant must take the loan first. A criteria for hardship, requires the participant exhaust all resources of obtaining monies to satisfy the financial need.
- The burden of proof is on the plan sponsor to assure a hardship request meets the IRS criteria.
- The amount withdrawn is limited to the participant’s 401(k) (including Roth) source only. No employer monies can be withdrawn on account of financial hardship in the MVP(k)plan. The participant is also limited to the dollar amount they can prove as hardship.
- The amount hardship amount cannot be repaid to the plan. So if the participant’s financial situation changes, they cannot put the money back into the plan.
- Participants who take a hardship distribution are required to suspend deferrals for six months afterwards. If there is an employer match, they miss out on those contributions during the suspension period.
- The hardship distribution is subject to ordinary income taxes. The participant will have to report the hardship distribution as taxable income in the year of distribution. If the participant is under the age of 59½, they may also be required to pay a 10% early distribution penalty in addition to the income taxes.
- Loss of compounding interest on the amount of the hardship distribution. This is one of the most detrimental consequences of taking a hardship distribution and it is something that participants often do not consider.