Many 401(k) and other qualified retirement plans allow plan participants, under certain circumstances, to take an in-service distribution prior to age 59½.

A participant in a plan such as a 401(k) or 403(b) generally can take a distribution only upon experiencing a specific life event, such as severing service from their employer, retirement, or full disability. In other words, a plan participant generally cannot take a distribution from their 401(k) or 403(b) plan while actively employed. A plan, however, can allow distributions (made to an active participant) under certain circumstances known as an “in-service” distribution. Unfortunately, a plan can’t allow in-service distributions from pre-tax and employee Roth contributions prior to age 59½. However, withdrawals from these sources are available, if the plan allows, in the case of financial hardship.

Unlike hardship distributions from a 401(k) or 403(b) plan, which can be made if a qualifying financial hardship has taken place, such a distribution from a governmental 457(b) plan can take place due to an unforeseen emergency.

What’s a Hardship Distribution?

A hardship distribution is an in-service distribution from a 401(k) or 403(b) plan because of a participant’s “immediate and heavy financial need.” Notably, a plan is not required to offer hardship distributions (it’s an optional plan provision).

Treasury Regulation §1.401(k)-1(d)(3)(i) states: “Determination of existence of an immediate and heavy financial need, and of amount necessary to meet need, must be made in accordance with nondiscriminatory and objective standards set forth in the plan.”

The intent of a hardship distribution is not to assist with ongoing expenses. Instead, it’s intended to help a participant, in immediate financial need, use such funds for a down payment on a principal residence or to prevent eviction, but not for mortgage payments or regular rent.

Most plans allow participants to satisfy the “immediate and heavy financial need” requirement if their expense qualifies for one of seven Internal Revenue Service (IRS) hardship safe harbors. A distribution deemed to be made because of an immediate and heavy financial need of the participant is allowed if the distribution is for one of the following reasons:

1. Medical expenses for the participant, their spouse, dependents, or primary beneficiary. IRS Publication 502 details what medical expenses qualify, including “costs of diagnosis, cure, mitigation, treatment, or prevention of disease and for the purpose of affecting any part or function of the body.” Notably, elective or cosmetic surgery does not qualify.
2. Costs directly related to the purchase of a principal residence for the participant (excluding mortgage payments).
3. Educational expenses for post-secondary education for the participant, their spouse, children or primary beneficiary under the plan. Payment of tuition and college-related expenses generally includes —books, boarding, educational fees, etc. It does not cover amounts that are already covered through a grant, scholarship or paid from a Section 529 college savings plan.
4. Payments needed to prevent eviction or foreclosure from the participant’s principal residence. The hardship amount is limited to the amount that is due to the mortgage company to prevent foreclosure or to the landlord for rent to prevent eviction.
5. Payments for burial or funeral expenses for the plan participant, deceased parent, spouse, child or dependent, or for a deceased primary beneficiary under the plan.
6. Damage to a primary residence: Notably, damage does not include regular wear and tear on the home, rather it must result from catastrophic events such as fire, flood, earthquake, tornado, and hurricane. For information on casualty losses, see IRS Publication 547, Casualties, Disasters and Thefts.
7. Federally declared disaster: Expenses and losses (including loss of income), incurred by a plan participant because of a disaster declared by the Federal Emergency Management Agency (FEMA), provided the participant’s principal residence or principal place of employment at the time of the disaster was located in an area designated by FEMA.

Notably, a plan is not required meet a participant’s “immediate and heavy” financial need by using these IRS safe harbors. A plan, instead, can define “immediate and heavy” financial need apart from these safe harbors. However, upon audit, any determinations made with respect to hardship will be subject to facts and circumstances.

Eligibility

To qualify for a hardship distribution, a plan participant must generally satisfy three conditions, including:

(1)  The plan must include a hardship provision.

(2)  The plan participant must have an immediate and heavy financial need. This means that the expense(s) is currently due.

(3)  The participant does not have other assets reasonably available to meet this need. This regulation requires that the participant has first obtained all other currently available distributions under all retirement plans maintained by their employer.

Previously, an employer was required to receive documentation (from the participant) to determine if the participant truly has an immediate and heavy financial need along with the amount required to satisfy that need. Now, the employer may rely on a participant’s self-certification that they have experienced a financial hardship and have no other available assets to satisfy the hardship unless they have knowledge to the contrary.

The plan sponsor is responsible for assessing the participant information, prior to approving it, to determine if it meets the “immediate and heavy” component of the hardship test.

The plan document will state what information/documentation must be provided to demonstrate a participant is experiencing a financial hardship.

Taxation

• A hardship distribution is generally subject to taxable income (in the year distributed) plus a 10% early distribution penalty tax should the participant be under age 59 ½ at the time of the distribution. The penalty however is assessed at the time the participant files their tax return for the calendar year of the distribution.
• A Roth 401(k) hardship distribution follows a different set of taxation rules. For example, a qualified Roth withdrawal (occurring after age 59½ and five years) are tax free, whereas non-qualified Roth withdrawals are taxed only on earnings and may be subject to the 10% early distribution penalty tax if the participant is under age 59 ½ at the time of the distribution.

457(b) Plan

A 457(b) plan can allow participants to take distributions arising from an “unforeseeable emergency.” For example, an unforeseeable emergency is defined as a severe financial hardship of a participant resulting from an accident or illness of the participant or their beneficiary, or of the participant’s or beneficiary’s spouse or dependents, property loss suffered by the participant or beneficiary due to casualty, or other similar, unforeseeable circumstances resulting from events beyond the participant’s or beneficiary’s control.

IRAs (including SEP and SIMPLE IRA)

An IRA owner can take a distribution from their traditional IRA, Roth IRA, SEP-IRA, or SIMPLE IRA at any age, time, or for any reason. What this means is the hardship distribution rules that apply to an employer-sponsored retirement plan (i.e., 401(k), 403(b), 457(b)) don’t apply to IRAs. An IRA owner instead can simply request a withdrawal—at any time—from their IRA. Although the distribution will generally be subject to ordinary income tax. Furthermore, just like a distribution from a qualified retirement plan taken before age 59 ½, the distribution may be subject to the 10% early distribution penalty tax unless an exception applies.

What else do I need to know about hardship distributions?

• A participant can withdraw only the amount of funds necessary to cover the amount of the hardship. However, the amount may be increased to cover taxes (federal and state, if applicable).
• A participant is no longer required to take a plan loan before taking a hardship distribution, although a plan can still require that all available loans be taken prior to requesting a hardship distribution.
• There is the elimination of the six-month suspension of participant salary deferrals following a hardship withdrawal.
• Earnings can now be distributed on account of a hardship distribution.
• Employer contributions are now available for hardship distributions, including safe harbor, qualified non-elective, and matching contributions.
• A hardship distribution cannot be rolled over to an IRA.
• A hardship distribution, unlike a plan loan, cannot be repaid.
• A hardship distribution due to an immediate and heavy financial need is separate from the new Secure Act 2.0 provision allowing for Emergency Expense Distributions. For example, a hardship distribution is not subject to a fixed-dollar cap, whereas an Emergency Expense Distribution is limited to a $1,000 maximum. Notably, Emergency Expense Distributions are not subject to the 10% early distribution penalty tax and can be repaid, whereas hardship distributions cannot.

Questions? Please contact your Lord Abbett representative at 888-522-2388.