Suspend Deferrals After a Hardship Distribution

Situation: Our 401(k) plan allows hardship distributions. We use the tax law’s safe harbor method of determining eligible hardships. We recently received a request for a hardship distribution and want to make sure we comply with all of the requirements.

Question: Is there anything we should take particular care with?

Answer: In addition to confirming that the distribution meets one of the six “immediate and heavy financial needs” under the safe harbor method rules, make sure you have suspended elective deferrals by the participant receiving the distribution for six months.

Discussion: Failure to suspend deferrals after a distribution is a common compliance error. Hardship distributions can be made only to satisfy an “immediate and heavy financial need of an employee.” To qualify, the employee must have obtained all other currently available distributions and loans from the plan and be prohibited from making elective deferrals to the plan for at least six months following the distribution.

The safe harbor method permits hardship distributions to: (1) pay certain medical expenses incurred by the participant, participant’s spouse, or dependents; (2) purchase a principal residence; (3) cover post-secondary educational expenses for the participant, the participant’s spouse, children, or dependents; (4) prevent eviction from or foreclosure on a principal residence; (5) pay the burial or funeral expenses of a spouse, parents, children, or dependents; and (6) pay expenses for the repair of damage to the participant’s principal residence that would qualify for the income-tax casualty loss deduction.

While many compliance errors can be corrected under the IRS’s Employee Plans Compliance Resolution System (EPCRS), the system doesn’t specify a correction for failing to suspend employee deferrals following a hardship distribution. However, the IRS has outlined two possible correction methods. A plan may return the improper elective deferrals, adjusted for earnings, to the participant. This option complies with the EPCRS general rule that the plan and the affected participant(s) be restored to the same position they would have been in had the failure not occurred. Alternatively, the plan could suspend elective deferrals for a six-month period going forward. This correction wouldn’t restore the participant to the same position if employer matching contributions for this period differed from those for the suspension period or if the employee quit employment before the end of the six-month period.