Here is what the IRS says in this guidance:
Although not required, a retirement plan may allow participants to receive hardship distributions. A distribution from a participant’s elective deferral account can only be made if the distribution is both:
- Due to an immediate and heavy financial need.
- Limited to the amount necessary to satisfy that financial need.
Immediate and heavy financial need
The employer determines a participant has an immediate and heavy financial need based on the plan terms and all relevant facts and circumstances.
- Consumer purchases (such as a boat or television) are generally not considered 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.
A distribution is automatically considered to be necessary to satisfy an immediate and heavy financial need if all of the following requirements are met:
- The distribution isn’t greater than the amount of the immediate and heavy financial need, including the amounts necessary to pay any taxes resulting from the distribution.
- The employee has obtained all other currently available distributions (including distribution of ESOP dividends under section 404(k), but not hardship distributions) and nontaxable (at the time of the loan) plan loans, including all other plans maintained by the employer.
- The employee isn’t allowed to make elective deferrals to the plan for at least six months after the hardship distribution.
Safe Harbor Distributions
Under a “safe harbor” in IRS regulations, an employee is automatically considered to have an immediate and heavy financial need if the distribution is for any of these:
- Medical care expenses for the employee, the employee’s spouse, dependents or beneficiary.
- Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments).
- Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary.
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
- Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
- Certain expenses to repair damage to the employee’s principal residence.
Limited to the amount necessary
The amount of a hardship distribution must be limited to the amount necessary to satisfy the need. This rule is satisfied if:
- The distribution is limited to the amount needed to cover the immediate and heavy financial need, and
- The employee couldn’t reasonably obtain the funds from another source.
Unless the employer has actual knowledge to the contrary, the employer may rely on the employee’s written statement that their need can’t be relieved from other available resources, including:
- Insurance or other reimbursement.
- Liquidation of the employee’s assets.
- The employee’s pay, by discontinuing elective deferrals and after-tax employee contributions.
- Plan loans or reasonable commercial loans.
An employee doesn’t have to use alternative resources if doing so would increase the amount of the need. For example, an employee requesting a hardship to purchase a principal residence doesn’t have to obtain a plan loan if the loan would disqualify the employee from obtaining other necessary financing.
Account balances eligible for hardship distributions
In a 401(k) plan, hardship distributions can generally only be made from accumulated:
- elective deferrals (not from earnings on elective deferrals)
- employer nonelective contributions (sometimes referred to as “profit-sharing contributions”) and
- regular matching contributions.
A plan may, but isn’t required to, apply the same conditions to hardship distributions of employer nonelective and regular matching contributions as it applies to hardship distributions of elective deferrals. Some 401(k) plans may allow hardship distributions of certain kinds of contributions made to the plan before 1989.
If you are an employer and:
- You didn’t make hardship distributions according to your plan document, find out how you can correct this mistake.
- You made hardship distributions but your plan doesn’t have language permitting them, find out how you can correct this mistake.
Tax treatment of hardship distributions
Hardship distributions are subject to income taxes (unless they consist of Roth contributions). They may also be subject to a 10% additional tax on early distributions. Employees who take a hardship distribution can’t:
- repay it to the plan, or
- roll it over to another plan or an IRA.