Both retirement plan sponsors and participants often have questions about 401k hardship withdrawals.  The following guide provides you with (1) Plan Sponsor Summary and (2)Frequently Asked Questions which can be shared with participants.

401k Hardship Withdrawals: A Plan Sponsor Summary

401k Hardship Withdrawals: Required Documentation

Most retirement plans allow for 401k hardship withdrawals, providing the hardship meets specific reasons as defined by the IRS. Typically there are six events that qualify as a “financial hardship.” These include:

• 

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  Purchase of a primary (owner-occupied) residence

• Un-reimbursed medical expenses
• College tuition (for participant or immediate family members)
• Payment to prevent eviction or foreclosure
• Payment for burial expenses
• One time natural disaster

Once you have determined the financial hardship request meets one of the above criteria, there are still two important items that must be obtained prior to granting 401k hardship withdrawals.

1. The participant must provide documentation of the event. The documentation could include escrow instructions, unpaid bills (medical, tuition, burial expenses, etc.), estimates for repairs due to natural disaster, or copies of pending foreclosure notices.
2. The participant must acknowledge they have exhausted all other sources to pay for this event. This may include the availability of plan loans, bank or home equity loans, and even credit card advances.

401k Hardship Withdrawals:  The Consequences

Finally, remember there are consequences for taking a financial hardship. Amounts withdrawn are subject to federal and state income taxes and a 10% federal excise (penalty) tax. As a result, the net proceeds of the hardship can easily be cut by 30-40% or more due to taxes and penalties. If that wasn’t enough, the participant must also be suspended from contributing to the plan for a period of six months following the hardship.

If you have any questions about your 401k hardship withdrawals provision, please contact your 401k advisor.

Sample 401k Hardship Withdrawals Notice for Participants

Please feel free to use our sample participant communications below.  Of course, you’ll want to consult with your specific plan documents to ensure that any participant communications accurately reflect your particular plan.

401k Hardship Withdrawals: Frequently Asked Questions

What are 401k hardship withdrawals?

Your 401k plan, through its financial hardship provision, allows an employee to withdraw money from their 401k plan for financial hardships. While each person may have their own definition of what a financial hardship is for them, federal law and your plan document define financial hardship as it relates to your 401k plan. Any violation could result in severe tax penalties for the person taking the illegal financial hardship withdrawal, and even possible disqualification of the entire 401k plan.

What specific events qualify for 401k hardship withdrawals?

Assuming your plan utilizes the safe harbor design, six events that qualify under IRS rules as a financial hardship include:

• College education (you or your dependents)
• Medical expenses (you or your dependents)
• Purchase of a primary home
• Prevent foreclosure on your primary home
• Funeral expenses
• Natural catastrophe

Will I have to provide supporting documentation of my hardship?

Most likely, yes. The documentation must show expenses that are incurred and explicitly fit one of the listed qualifying events. Examples of these include but are not limited to copies of escrow instructions, unpaid medical bills, copies of college tuition payments, and eviction/foreclosure notices.

Are there any tax consequences for taking a financial hardship withdrawal?

You may owe at least three and possibly four different types of taxes on your financial hardship, including federal and state income tax, a 10% federal excise (penalty) tax, and possibly a state excise (penalty) tax. Your financial hardship distribution must be added to your annual income for federal and state income reporting purposes. Failure to do so could result in further penalty taxes by the IRS. You are strongly advised to consult a tax professional regarding these issues.

How much may I withdraw?

Your withdrawal, if approved, will be limited to the total of the documentation furnished plus the 10% federal excise (penalty) tax. For example, if you qualify for a $10,000 financial hardship withdrawal, you may withdraw $10,000 + $1,000 that will be used to pay the 10% federal excise (penalty) taxes. Most plans only allow your vested account balance to be withdrawn for a financial hardship. Stated differently, any employer contributions to your 401k plan that are not yet vested are not eligible for a financial hardship withdrawal.

May I still participate in the 401k plan after taking a financial hardship withdrawal?

Most plans suspend you from participating (making your own contributions) in the 401k plan for six months after receiving a financial hardship withdrawal.

What is the process for requesting 401k hardship withdrawals?

Before an employee may request a financial hardship withdrawal, most plans require you to exhaust all other financial avenues available to you. That means that you must attempt to obtain a loan through commercial means, and if you are unsuccessful on the commercial front, via the loan provision in the 401k plan. If you already have an outstanding loan, or you do not qualify for a loan under the terms of your 401k plan, you may then pursue a financial hardship withdrawal. The process to complete a financial hardship application varies with each plan. Please check with Human Resources to acquire any necessary direction or documents necessary to acquire a distribution.

Is there anything else I should consider before taking a 401k withdrawal?

A financial hardship withdrawal should be the last resort to obtain money. Again, you must first consider other methods of borrowing, including bank loans, credit card cash advances, equity home loans, and even the 401k loan provision (if applicable). Please consult your tax advisor or financial planning professional for advice about the most cost effective way to access money that you need for purposes of meeting your financial hardship needs.

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