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Requiring and retaining proof of the hardship—such as employees’ late-payment notices—is crucial
Requests by 401(k) plan participants to take hardship distributions from their accounts can turn into an administrative hardship for HR plan administrators, but there are ways to make handling these requests work—both for employees and benefit managers.
Robert M. Kaplan, national training consultant for retirement business at Voya Financial, shared tips during a session he presented at the 2015 annual conference of the American Society of Pension Professionals & Actuaries (ASPPA), held Oct. 18-21 at National Harbor, Md.
Neither loans (meant to be temporary withdrawals to be paid back with interest) nor hardship withdrawals (which are permanent and invoke penalties as well as taxes) are required to be offered by 401(k) plans. Instead, both are options that most but not all 401(k) plans choose to provide under the terms of the plan document, “and some plans provide one but not the other,” explained Kaplan, a member of the ASPPA board of directors and co-chair of its government affairs executive committee.
Specifically, about 88 percent of 401(k) plans have an option for taking loans, and 88 percent allow hardship withdrawals, “but it’s not the same 88 percent,” as some plans offer one but not the other.
Benefit administrators should bear in mind that under IRS regulations:
• Loans must be paid back over five years, although this can be extended for a home purchase. While loan interest rates vary by plan, the rate most often used is the "prime rate" plus one or two percentage points. Interest is paid back into the participant's 401(k) account. If not repaid within five years, the loan amount is treated as a distribution and, if participants are not at least 59½ years old, they must pay a 10 percent penalty on top of income taxes on the withdrawn funds.
• Hardship withdrawals are subject to certain IRS restrictions. The withdrawal amount is subject to income tax and, if participants are not at least 59½ years old, a 10 percent withdrawal penalty. Participants do not have to pay the withdrawal amount back, which means their ultimate retirement savings will be much more seriously impacted.
The IRS permits 401(k) plans to allow hardship withdrawals for six reasons:
1. To pay for unreimbursed medical expenses for plan participants or their spouse or dependents.
2. To purchase of a plan participant's principal residence, excluding mortgage payments.
3. To pay college tuition and related post-secondary education costs such as room and board for the next 12 months for a plan participant, spouse, dependent or child who is no longer a dependent.
4. To make payments necessary to prevent eviction from a plan participant’s principal residence, or foreclosure on the mortgage of the principal residence.
5. To pay funeral expenses for plan participants and their spouse, children, dependents or beneficiary.
6. To pay for repairs to the plan participant’s principal residence if the repairs fall under the IRS’s description of a casualty loss. The damage must be from an event that is sudden, unexpected or unusual.
“The hardship distribution amount may not exceed the amount needed to satisfy the hardship, but may be ‘trued up’ to cover the taxes and penalties,” Kaplan noted. Distributions are limited to the elective deferral amount not including earnings.
The terms of the plan should include the procedures the employee must follow to request a hardship distribution (if allowed), and the plan’s definition of a hardship, which can include any or all of the six reasons permitted by the IRS.
The allowable reasons for hardship withdrawals are not as clear-cut as they might at first seem, HR professionals often learn. For instance, the IRS has said that a withdrawal to purchase a residence for family members excluding the employee isn't allowed, but what do you do when the employee says he’s living with his girlfriend and she’s about to be evicted?
The rules would say no, unless the employee is added to the lease before the eviction—or the girlfriend becomes a spouse or legal dependent, Kaplan observed.
For medical, education and funeral expenses, the rules have been interpreted to extend to hardships incurred by named beneficiaries under the plan, “but the individual must be the primary beneficiary at the time that the hardship occurred—participants can’t change the beneficiary designation after the hardship,” Kaplan noted.
-------------------------------------------------------------What do you do when the employee says he’s livingwith his girlfriend and she’s about to be evicted?-------------------------------------------------------------
Documentation and Record Retention
The IRS has said that “the plan administrator must have enough information to adjudicate the claim,” which means sufficient documentation to make an informed decision, before instructing the plan trustee to release the funds.
“Unfortunately, ‘proof’ is not defined in the regulations,” Kaplan said. He advised that “collecting the paperwork now can save a lot of hassle after the fact if questions or an audit occur.”
“Employees can become creative about stretching the rules,” Kaplan noted. “Just saying they’re behind on their mortgage payments or rent isn’t enough. They should provide proof that an action is going to be taken on foreclosure or eviction.” This means the participant should request documentation from his or her landlord or mortgage company, for instance. And the plan administrator should keep these documents on file.
When an impending foreclosure or eviction is cited, plan administrators must make judgments, such as “How threatening is the letter about future payments?” Kaplan said.
“It’s the employers’ responsibility to maintain records,” the IRS has said, Kaplan pointed out. When being audited, employers can face penalties if the IRS finds a lack of documentation such as participants’ invoices, late-payment notices and bills.
“Self-certification by the employee is not acceptable,” he reiterated. “Make sure administrative practices and procedures are in place. You cannot delegate away responsibility for documentation.”
If plan administration including the handling of hardship requests is outsourced, HR should ensure that the service provider is maintaining these records and can provide them to the employer on request, because “it’s the employer that will be audited,” he emphasized.
Plan sponsors should retain the following records in paper or electronic format, or ensure they have access to them from their service provider:
• Documentation of the hardship request, review and approval.
• Financial information and documentation that substantiates the employee’s immediate and heavy financial need. The plan administrator should be comfortable that the documentation will be sufficient in an audit situation.
• Documentation to support that the hardship distribution was properly made in accordance with the applicable plan provisions and the tax code.
• Proof of the actual distribution made and related Forms 1099-R.
Loans First, Usually
“IRS rules require that all other distributions and nontaxable loans from all plans of the same employer be taken first,” Kaplan said. While generally this would mean taking a loan before a hardship withdrawal in plans that provide for both, there are exceptions if the loan would be counterproductive. “A hardship withdrawal may be more appropriate if a loan would increase the participant’s debt to the extent it would jeopardize his or her home loan, for instance,” Kaplan said.
“This does not mean that all plans must have a loan provision,” he added.
As for what exactly could be deemed to be counterproductive, “there is no criteria in the regulations, so documentation should be kept” in support of the plan sponsor’s decision to permit a hardship withdrawal over a loan.
Help Managing Budgets
A survey last year by the National Association of Plan Advisors (NAPA), a sister organization of ASPPA, found that “It’s my money and why can’t I have it?” was “one of the most frustrating questions plan sponsors receive from participants,” Kaplan said.
To avoid this situation, plan sponsors with high rates of participant loan and withdrawal activity may want to consider offering their employees tools and educational resources to help them improve their budgeting skills and increase their ability to save. A 2014 study by the Society for Human Resource Management showed that workers are looking to their employers for help managing their overall financial wellness.
Among HR professionals who indicated their organization provides financial education, 72 percent reported these initiatives have been somewhat or very effective in improving their employees’ financial well-being.
Stephen Miller, CEBS, is an online editor/manager for SHRM. Follow me on Twitter.
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