Handling Erroneous Hardship Distributions

With the housing crisis and uncertain economy, some plan sponsors have seen an uptick in requests for hardship distributions from their 401(k) plans. If you receive a hardship request, take care that any distribution you make meets IRS requirements and your plan’s provisions. Below, we answer questions about hardship distributions and how to correct erroneous distributions.

When can a 401(k) plan make a hardship distribution? It depends on the method used to define hardship. When a plan uses the facts-and-circumstances method, the plan administrator reviews all relevant facts and circumstances in each individual situation. While the plan generally can allow a hardship distribution for any reason, it must have established rules to ensure that the distribution will be used for an immediate and heavy financial need.

For example, the need to pay funeral expenses of a family member would constitute an immediate and heavy financial need. A distribution made for the purchase of a boat or television would generally not be considered a distribution made on account of an immediate and heavy financial need. A financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee.

Under the safe-harbor method, a plan can allow hardship distributions to be taken for the following reasons: (1) to pay certain medical expenses incurred by the participant or the participant’s spouse or dependents; (2) to purchase a principal residence; (3) to cover post-secondary educational expenses for the participant or the participant’s spouse, children, or dependents; (4) to prevent eviction from or foreclosure on a principal residence; (5) to pay the funeral expenses of a spouse, parents, children, or dependents; and (6) to repair damage to the employee’s principal residence that would qualify for the income-tax casualty loss deduction (without regard to whether the loss exceeds 10% of adjusted gross income).

Plans using a safe harbor method must restrict the employee from contributing to the plan (and all other qualified and nonqualified plans maintained by the employer) for a minimum of six months following the hardship distribution.

What should a plan sponsor do if it discovers that a hardship distribution has been made in error? A plan generally can use either the IRS’s Self-Correction Program (SCP) or Voluntary Correction Program (VCP), as set forth in Revenue Procedure 2006-27, to correct a hardship distribution error, unless the plan is under IRS examination. In that case, the plan generally will have to correct the mistake in accordance with a closing agreement under the Audit Closing Agreement Program (Audit CAP).

Take reasonable steps to ensure that the employee who received the distribution returns the erroneously distributed amounts to the plan. The employee also should be informed that any amounts not returned are not eligible for favorable income-tax treatment.

For example, these amounts cannot be rolled over to an IRA or another retirement plan. To ensure the error doesn’t occur again, review plan procedures for approving hardship distributions and make sure that everyone with authority to authorize distributions is aware of those procedures.

What can be done to avoid mistakes? The IRS recommends (1) reviewing the plan document to see when and under what circumstances distributions can be made, (2) establishing hardship distribution procedures, and (3) looking for signs that the hardship distribution feature is being abused or badly managed. For example, too many hardship requests from employees in one department or division or from only highly compensated employees may be a sign of abuse or that all employees haven’t been properly notified of the availability of hardship distributions.