Outward "Bound"

With the declining economy, employees are finding it increasingly difficult to make ends meet. As a result, many are looking to their 401(k) plans as a potential source of funds to prevent eviction, avoid foreclosure, or pay escalating medical expenses. For this reason, it is timely to review the rules on hardship distributions from 401(k) plans.

A 401(k) plan may—but does not have to—be designed to permit an in-service, hardship distribution due to an immediate and heavy financial need that cannot be met by other sources. A distribution is deemed necessary to meet this financial need if (i) the employee has obtained all other currently available distributions and loans under the plan and all other plans maintained by the employer and (ii) the employee’s contributions (both pre-tax and after-tax) to the plan and all other plans maintained by the employer are suspended for at least six months after receipt of the hardship distribution. Also, the amount of the hardship must be limited to the amount of the employee’s financial need. However, the amount necessary to satisfy the financial need may include amounts necessary to pay any penalties (e.g., 10% excise tax, which may apply if the individual is younger than age 59 1/2) and federal, state, or local income taxes resulting from the hardship distribution.

The determination of whether an immediate and heavy financial need exists involves a facts and circumstances determination by the plan fiduciary, unless the plan has elected to follow the IRS safe harbor. The IRS safe harbor deems the following expenses as involving an immediate and heavy need: (i) medical expenses not covered by insurance for the participant or the participant’s spouse, dependent, or primary beneficiary; (ii) costs related to the purchase of the participant’s primary residence (not including mortgage payments); (iii) expenses for educational fees, tuition, and room and board for up to the next 12 months of post-secondary education for the participant or the participant’s spouse, children, dependents, or primary beneficiary; (iv) payments necessary to prevent eviction from (or foreclosure on a mortgage) the participant’s principal residence; (v) payments for burial and funeral expenses for the participant’s deceased parent, spouse, children, dependents, or primary beneficiary; and (vi) certain expenses for repairing damages to the participant’s principal residence. Note that the definition of “primary beneficiary’ used above means the individual who is named as a beneficiary under the plan and who has an unconditional right to all or a portion of the participant’s account balance under the plan upon the participant’s death. A plan is permitted, but not required, to use some or all of the safe harbor events described above and is permitted, but not required, to include an expanded hardship distribution definition, which extends to the primary beneficiary.

Even if a plan uses the IRS safe harbor events, care must be applied to determine when such events have occurred. For this reason, a plan should require supporting documentation that includes, at a minimum, independent evidence demonstrating the existence of the event requiring a hardship distribution and the dollar amount involved. The supporting documentation could include, depending on the particular event, letters from insurers denying medical coverage, residential purchase agreements, legal notices such as eviction notices and foreclosure notices, and provider bills. All such documentation should be retained as part of the plan’s records.

Although a hardship distribution provision is an optional plan design feature, given the trying economic times, it may be a significant financial lifeline for employees who find themselves in dire economic straits. Therefore, a prudent course of action is to review plan documents; determine whether to include a hardship provision if it is not already in the plan; decide whether the hardship provision has been updated to include some or all of the permitted and expanded features (e.g. burial and casualty expenses, as well as expenses for a primary beneficiary); review plan document retention policies related to hardship determinations; and review the operations related to hardship determinations (e.g., implementation of steps to ensure that all plan loan options are exhausted before granting a hardship distribution). The upfront attention to these details may prove invaluable to employees currently facing difficulty and to those who may find themselves in trouble in the future.

Quana C. Jew is a partner at the law firm of Arent Fox, focusing on ERISA, employee benefits, and executive compensation. Quana has served as a guest lecturer in the employee benefits area for various law school, bar seminar, and employee benefits-related organizations. Most recently, Washingtonian magazine named Quana as one of Washington’s best tax lawyers.