Hardship Withdrawals
General Requirements Under the Code
In-service retirement plan distributions other than hardship withdrawals are typically limited to those participants who have attained age 59 ½. The Code permits hardship withdrawals specifically for the purpose of addressing an immediate and heavy financial need. Unlike plan loans, however, hardship withdrawals are immediately considered taxable distributions and subject to a mandatory 20 percent withholding tax and a 10 percent early withdrawal tax (if the hardship withdrawal is taken prior to participant’s attainment of age 59 ½). Most plans limit hardship distributions to the IRS-stipulated “safe harbor” reasons as follows:
- Expenses related to Code Section 213(d) medical care;
- Costs related to the purchase of primary residence for the employee (excluding mortgage payments);
- Payment of educational expenses for up to 12 months of post-secondary education for the employee;
- Payments necessary to prevent the eviction of the employee from his or her principal residence;
- Payments for burial or funeral expenses for certain family members of the employee;
- Expenses for repair of damage to the employee’s principal residence that would qualify for the casualty loss deduction (without regard to the 10% adjusted gross income limit); and
- Expenses and losses (including the loss of income) incurred by the employee on account of a FEMA-declared disaster, provided the employee’s principal residence or principal place of employment is in the disaster area
Coronavirus and Hardship Safe Harbors
A plan does not have to permit a hardship for all the safe harbor events; it can include one or more of the permissible events. Two safe harbor expenses that may include Coronavirus-related expenses include expenses for medical care (for the employee, employee’s spouse, employee’s dependents, or the employee’s primary beneficiary) to the extent such care is deductible under Code Section 213(d). Another safe harbor that may include Coronavirus-related expenses includes expenses related to the prevention of eviction or foreclosure on a primary residence. However, in recent weeks, eviction and home foreclosures have been suspended by the federal government (for HUD housing), certain cities and states.
To date, FEMA has not declared Coronavirus a disaster (and historically has not declared a disaster for other virus outbreaks (such as Zika, H1N1, and SARS)). However, given the impact that Coronavirus has had across the U.S., future guidance on this issue is likely. If FEMA declares Coronavirus a natural disaster, a hardship withdrawal could be received for any Coronavirus-related reason. Note that President Trump’s recently declared national emergency does not constitute a FEMA disaster and, therefore, does not include Coronavirus-related expenses under the FEMA-declared disaster definition. There is an alternative hardship definition that plan sponsors could opt to use. This is a non-safe harbor definition and is based on facts and circumstances. Under this definition, a sponsor can allow a hardship request for any immediate and heavy financial need. They would not be limited to the six reasons outlined by the IRS.
Changes to Hardship Withdrawals Under the CARES Act
The CARES Act includes an exemption of qualified individuals from the 10-percent early withdrawal tax for the first $100,000 Coronavirus-related hardship distributions. This exemption is an aggregate limit and applies across the employer’s controlled group. These distributions would not be subject to the general IRS early-withdrawal penalty of 10 percent, but pre-tax contributions that are distributed would be subject to income tax. The CARES Act permits any income tax owed to be spread out over three years unless the individual elects to the contrary.
To be considered an eligible Coronavirus-related distribution, the distribution must be made to individuals under similar circumstances as those described above for expanded plan loans (e.g., an individual who is diagnosed with the SARS-CoV-2 virus or Coronavirus). The amount of the Coronavirus-related hardship distribution must be repaid within three years of the date the distribution was originally received. Such repayment may be made in one or more payments (with no required minimum repayment) over the three-year time period. If the borrowing participants elects not to repay the loan, such distribution will be included in his or her income ratably over a three-taxable-year period beginning with the taxable year in which the withdrawal was taken.
Employer Considerations for Hardship Withdrawals
For employers with retirement plans that permit hardship withdrawals, retirement plan fiduciaries should consider the following:
- The plan is responsible for determining the need described in the hardship request satisfies the amount requested. Therefore, retirement plan fiduciaries must carefully review and compare the hardship withdrawal documentation with the amount requested by the participant
- Retirement plan fiduciaries should maintain (or develop) a comprehensive paradigm for hardship withdrawal requests, including documentation provided by the participant to justify the immediate need for a hardship withdrawal. Failure by retirement plan fiduciaries to properly maintain documentation may have negative consequences for the plan (for example, a determination by the IRS that the hardship withdrawal was an impermissible distribution).
- In this time of extreme financial uncertainty, retirement plan fiduciaries with a hardship safe harbor definition should consider whether to expand the hardship definition to include any immediate and heavy financial need. This change is likely to ensure that those impacted by Coronavirus have access to hardship withdrawals if the need arises
- Coronavirus has significantly disrupted operations for retirement plan vendors making it even more important for retirement plan fiduciaries to review their vendor contracts to determine what guarantees and indemnification provisions apply to vendor performance
Retirement Plans Without Loans or Hardship Withdrawal Provisions
Considering the financial hardship precipitated by Coronavirus, those employers with retirement plans that do not currently allow for loans or hardship withdrawals may want to reconsider. Plan sponsors intending to amend the plan to add these in-service withdrawal alternatives can allow participants to take advantage of loans and hardship withdrawals immediately. The plan, however, must be amended to accommodate these changes prior to the end of the plan year. Retirement plan fiduciaries interested in incorporating loans and hardship withdrawals will need to consider the long-term impact such withdrawals may have on participant account balances as the stock market plummets. In these unprecedented times, retirement plan fiduciaries must carefully consider whether provision of in-service withdrawals is ultimately in the best interest of plan participants, particularly for those in industries hardest hit by Coronavirus and the resulting financial downturn.
Hall Benefits Law, LLC
