Tax Consequences Of Retirement Plan Hardship Distributions For Employees And Employers

October 1, 2009 by: The Tax Man

Tax Consequences Of Retirement Plan Hardship Distributions For Employees And Employers During the economic slowdown, many individuals are looking to their retirement savings to augment their unemployment benefits or help carry them through a period of hardship. With a lack of other cash sources, individuals are taking plan loans and hardship distributions from their retirement funds. The IRS recently advised employers and employees on the tax consequences of employee plan loans and hardship distributions.

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Hardship distributions Retirement plans such as 401(k) and 403(b) plans may permit participants to withdraw certain amounts from their plan due to a financial hardship. However, there are very specific and detailed guidelines that employees and employers must follow to ensure “hardship distributions” comply with the Tax Code and other laws. Generally, hardship distributions are allowed only if the plan permits such distributions, because of an immediate and heavy financial need of the employee (or in some situations the employee’s spouse, dependent or beneficiary), and in an amount necessary to meet the financial need. Hardship distributions are not tax-free, the IRS reminded taxpayers. Generally, they are subject to income tax in the year distributed and, if the taxpayer is under the age of 59 1/2, are also subject to the 10 percent early withdrawal penalty (unless an exception applies). For example, for retirement plans the 10 percent penalty on distributions made before the taxpayer reaches age 59 1/2 does not apply if the recipient of the distribution is at least age 55 and retired, or if the recipient chooses to receive the distribution in uniform and regular payments after retiring. The 10 percent penalty also does not apply to IRAs if the early distribution is used to pay medical insurance premiums while the recipient is unemployed, for qualifying higher education expenses, or to buy, build, or rebuild a primary residence. However, hardship distributions are not subject to the mandatory 20 percent income tax withholding. Checklist The IRS suggested that employers follow seven steps before making hardship distributions: (1) Review the terms of the retirement plan to verify that the plan allows for hardship distributions. (2) Require employees to comply with the plan’s procedures for requesting hardship distributions. (3) Verify that employees’ reasons for requesting hardship distributions meet the plan’s definition of hardship. (4) Verify and document that employees have exhausted other sources of financial help, including loans from the retirement plan, if provided, before approving hardship distribution. (5) Verify that the amount of the hardship distribution does not exceed the financial need and any taxes or penalties assessed on a hardship distribution. (6) Verify that the amount of the hardship distribution does not exceed limits under the plan and does not come from amounts that are ineligible for hardship distributions. (7) Enforce any plan provisions that prevent employees from contributing to the plan for a fixed number of months after receiving a hardship distribution