What plan sponsors need to know about 401(k) hardship withdrawals

Important considerations for offering hardship withdrawals

While hardship provisions are commonly found in 401(k) plans, they’re not required. It’s up to you to determine if the feature makes sense for your plan. Several factors may influence your decision, including:

• Plan objectives and participant needs
• Administrative complexity
• Recordkeeping processes
• Compliance requirements

Here are some frequently asked questions to help you make an informed decision.

What’s considered a financial hardship?

You have some flexibility in defining the types of events that are considered a financial hardship under your plan. However, most plan sponsors use the IRS’s two-part safe harbor definition to simplify plan administration.

1 Immediate and heavy financial need

A participant is considered to have an immediate and heavy financial need if the money is for:

• Medical expenses for themselves, their spouse, or dependents
• Purchase of their primary home, excluding mortgage payments
• Tuition and related expenses for post-secondary education for themselves, their spouse, children, or other dependents
• Preventing eviction from, or foreclosure on, their primary home
• Funeral expenses for themselves, their spouse, children, or other dependents
• Certain expenses to repair damage to their primary home
• Expenses and losses (including loss of income) caused by a federally declared disaster if their principal residence or workplace is in the disaster zone

2 Limited to the amount necessary

To satisfy this rule, the participant:

• Must be unable to reasonably access the needed funds from another source, such as insurance or a loan
• Can’t withdraw more than the amount needed to cover the hardship

Do plan sponsors have to approve hardship withdrawals and collect supporting evidence of the hardship?  

Most plan recordkeepers or third-party administrators (TPAs) administer the hardship process for their plan clients. However, many do not assume fiduciary responsibility for approving the hardship requests and/or collecting the supporting evidence, unless specifically agreed to under their service arrangement with the plan sponsor.

As a result, plan sponsors remain responsible for demonstrating that hardship withdrawals were in accordance with the plan document and applicable IRS requirements. In addition, if an IRS auditor requests supporting evidence of certain hardship withdrawals taken during the audit year, the plan sponsor ultimately bears that responsibility of producing the requested information.

Fortunately, the SECURE 2.0 Act significantly simplified hardship withdrawals from retirement plans by allowing plan sponsors to rely on a participant's self-certification that they have an immediate and heavy financial need. As a result, much of the paperwork that historically accompanied hardship requests is no longer required.

Under Section 312 of SECURE 2.0, you can rely on a participant’s self-certification for their hardship withdrawal—unless you have actual knowledge that it isn’t accurate. The certification must state that:

• The withdrawal is for one of the IRS safe harbor reasons listed above.
• The amount requested doesn’t exceed the participant’s financial need.
• They have no other resources reasonably available to cover it.

Note: You don’t have to use the self-certification option. It’s simply an alternative to the approval and collection approach.

What types of contributions can be used for hardship withdrawals?

While employee pretax deferrals are typically used for hardship withdrawals, you can also allow participants to take out:

• Roth deferrals
• Qualified nonelective contributions (QNECs)
• Qualified matching contributions (QMACs)
• Regular matching contributions and safe harbor matching contributions
• Regular nonelective contributions and safe harbor nonelective contributions
• Earnings on elective deferrals and employer contributions

Note: For regular matching and nonelective contributions, participants must meet your plan's vesting rules.    

Expanding your hardship provision to include employer contributions requires careful consideration. While this can give participants more options in an emergency, it can also make plan administration more complex and potentially increase plan leakage.

Are hardship withdrawals taxable?

Yes. Unlike plan loans, hardship withdrawals are included in a participant’s gross income for the year of distribution, unless the money was taken from Roth or after-tax contributions. This means they’ll have to pay federal and possibly state income taxes on the withdrawal, plus a 10% penalty if they’re under age 59½. The distribution is reported on IRS Form 1099-R and provided to the participant in the January following the year of the withdrawal.

Can plan sponsors require participants to take a loan first?

Yes. You have the option to make participants take a plan loan before taking a hardship withdrawal. And it’s worth considering. Loans are repaid to the plan and are generally not taxable, which isn’t true for hardship withdrawals. For these reasons, a loan may be more beneficial for your participants in the long run.

Can participants keep contributing if they take a hardship withdrawal?

Yes. Years ago, participants had to suspend contributions to their 401(k) plan for six months after taking a hardship withdrawal. That rule no longer applies. They can continue making contributions as usual, helping them keep their retirement savings on track.

What are a plan sponsor’s responsibilities?

As the plan sponsor, you’re ultimately responsible for ensuring that all hardship withdrawals follow the terms of your plan document and are processed correctly. Any missteps can affect your plan’s qualified status. So, you’ll want to work closely with your retirement plan provider.

How should plan sponsors communicate about hardship withdrawals?  

While hardship withdrawals can provide much-needed relief in a time of financial crisis, it’s important for participants to understand the tradeoffs before taking one. A good way to do that is by making hardship withdrawals part of your participant education program.

Topics to consider include:

• The benefits and drawbacks of hardship withdrawals, including potential tax consequences
• The value of building an emergency savings fund for unexpected expenses
• Other available sources of funds, such as insurance benefits or a plan loan
• The long-term impact and the time it may take to rebuild their savings

Encourage saving by offering hardship withdrawals

Employees who are worried about their current financial situation may hesitate to set money aside in a retirement account they won’t be able to touch for years or even decades. A well-designed hardship withdrawal provision can turn that hesitation into action, putting them on the path toward the future they want.