In the Summer 2009 Retirement News For Employers, the IRS provides guidance on permitting employees to take withdrawals from retirement plans. The IRS notes that, under law, some retirement plans, for example 401(k) and 403(b) plans, may allow participants to withdraw certain amounts from the plan because of a financial hardship. IRS regulations provide guidelines for plans to follow to ensure they satisfy the law's requirements. Under these requirements, a plan can make a hardship distribution only:
-if permitted by the plan;
-because of an immediate and heavy financial need of the employee and, in certain cases, of the employee's spouse, dependent or beneficiary; and
i-n an amount necessary to meet the financial need.
The IRS lists the following 7 steps for an employer to take when permitting a hardship withdrawal from a retirement plan to which the above legal requirements apply:
Step 1 - Review the terms of your plan, including whether the plan allows hardship distributions, and the plan's procedures and limits which apply to an employee's request for a hardship distribution.
Step 2 - Ensure that the employee complies with the plan's procedural requirements.
Step 3 - Verify that the employee's specific reason for hardship qualifies for a distribution using the plan's definition of what constitutes a hardship.
Step 4 - If the plan, or any of your other plans in which the employee is a participant, offers loans, document that the employee has exhausted them prior to receiving a hardship distribution. Likewise, verify that the employee has taken any other available distributions, other than hardship distributions, from these plans.
Step 5 - Check that the amount of the hardship distribution does not exceed the amount necessary to satisfy the employee's financial need. However, the amount required to satisfy the financial need may include amounts necessary to pay any taxes or penalties that are due because of the hardship distribution. Under some plans, a hardship distribution is not considered necessary if the employee has other resources available, such as spousal and minor children's assets (excluding property held for the employee's child under an irrevocable trust or under the Uniform Gifts to Minors Act).
Step 6 - Make sure that the amount of the hardship distribution does not exceed any limits under the plan and is made only from the amounts eligible for a hardship distribution.
Step 7 - Most plans also specify that the employee is suspended from contributing to the plan and all other plans that the employer maintains for at least six months after receiving a hardship distribution. Inform the employee and enforce this provision. Failing to enforce the plan's suspension provision is a common plan error but may be corrected through the IRS's Employee Plans Compliance Resolution System (the "EPCRS").
The newsletter has some more on hardship withdrawals in a topic entitled "ABCs of Loans and Hardship Distributions."
The IRS also cautions employees to know the tax rules before taking a withdrawal from a retirement plan. It says that if you are under age 59 ½ and plan to withdraw money from your retirement account, you will likely pay both income tax and a 10% early distribution tax on any previously untaxed money that you take out. Withdrawals from a SIMPLE IRA before you are age 59 ½ and during the "2-year period" may be subject to a 25% additional early distribution tax instead of 10%. The 2-year period is measured from the first day that contributions are deposited. So, consider the decrease in your retirement savings and the increase in tax before you withdraw from either your IRA or a retirement plan, for example, a 401(k) or 403(b) plan.
There are some different exceptions to the 10% early distribution tax depending on whether you take money from an IRA or a retirement plan. Exceptions for an IRA include using the amount withdrawn (1) to pay medical insurance premiums while unemployed, (2) to pay qualified higher education expenses, or (3) to buy, build or rebuild a first home. An exception also applies if you receive distributions in the form of an annuity. Exceptions for retirement plans include (1) you separate from service and are age 55 or older in that year or (2) you elect to receive the money in substantially equal periodic payments after separation from service.