515-223-5119 [email protected]

[Author: Lesley Sifers, Tax Favored Benefits, Inc., 2010; R-2013 | Keywords: Human Resources, Retirement]

There’s no doubt, times are tough and a lot of people, even those with steady jobs, are having trouble paying the bills. Perhaps a spouse has lost his/her job so the household income is lower. In general, things like gas and groceries are more expensive than they were a year or so ago.

For many, wage increases haven’t kept up with inflation, but at least they still have a job. Then comes the unexpected. The car needs repaired or someone in the family gets sick and there is no money to pay the doctor bills. If people had any savings to start with, it’s already been spent. Where do they turn for money?

Increasingly, people are looking to their retirement plan accounts as a source of cash. For many, that is their biggest asset. Plus, they get a statement every quarter reminding them of how much they have saved for retirement. But it’s hard to think about something that is 20, 30, even 40 years in the future when you are strapped for cash NOW! That’s when they come to you or whoever handles the administration of your retirement plan, and ask to withdraw their money. Most of them will say, “But, it’s MY money and I need it NOW!”

The first thing to understand is that options for in-service withdrawals are limited in two ways. First, the regulations governing qualified plans only permit such withdrawals under certain conditions. Second, the Plan Document you have adopted spells out which of those conditions you have chosen to allow in your specific plan. The most common in-service withdrawal provisions are participant loans (roughly 35 percent of plans permit loans) and hardship withdrawals.

Hardship withdrawals are complicated, administratively burdensome, and expensive for participants. On the other hand, they are sort of a “safety valve.” Requests for hardship withdrawals have risen sharply over the past two years. In the past, a small plan with less than 100 participants might expect to deal with such a request once every few years. Now is it common to see five to ten such requests annually.

Most plans that permit hardships have adopted a “safe harbor” hardship provision. This means that if you follow the provisions as approved by the IRS, your plan should pass muster if audited. Here is a summary of the safe harbor hardship rules:

Permissible reasons for withdrawal:

  • Payment of medical /dental expense not covered by insurance for participant or dependent.
  • Payment of rent or mortgage payments to prevent eviction or foreclosure.
  • Payment of certain costs associated with purchase of a primary residence of the participant.
  • Payment of college expense for the participant or a dependent for the upcoming term.
  • Payment of funeral expenses for a parent, spouse or dependent.
  • Payment of repairs to participant’s primary residence if damage qualifies as a casualty loss for income tax purposes.

Other Requirements:

  • Participant must show they have no other means to raise the money they need. They must first obtain all distributable funds (such as unrelated rollover assets) and access the plan’s loan provision (if there is one) before being eligible for hardship withdrawal.
  • In most plans, only NET employee contributions can be withdrawn.
  • Participant must provide written, third party documentation of the reason for the need and the amount required. They cannot withdraw more than can be supported by this documentation.
  • Participant cannot contribute to the plan for six (6) months following withdrawal and, therefore, cannot receive employer-matching contributions.
  • Most plans limit in-service withdrawals (other than loans) to two per plan year.

Taxation:

Hardship withdrawals are taxable although the normal, mandatory federal tax withholding does not apply. The participant can elect to have withholding apply with a minimum rate of 10 percent. Some states also have mandatory state withholding rules and, if a participant elects federal withholding, state withholding will automatically apply. If the participant is under age 59-1/2, an additional 10 percent early withdrawal penalty must be calculated when they file taxes.

The information I have just given you may seem pretty straightforward so you could be thinking, “That doesn’t seem like such a big deal.” Well, here are some real stories that may make you think again. Keep in mind that the hardship withdrawal check is payable to the participant so there is no guarantee that he or she will actually pay their debt(s).

  • A participant applied for a hardship to pay past due rent. Documentation was a letter from his wife who said she was going to “throw him out” if he didn’t get some money pretty soon. Request denied.
  • Hardship was for medical bills and documentation consisted of statements from medical providers three to five years ago. Also submitted (possibly by mistake) was a list of bills discharged in bankruptcy court, including the same medical bills. Request denied.
  • Participant applied for hardship withdrawal in January for three months of mortgage payments. A second withdrawal in April was for four months of mortgage payments. Documentation was in order and both were approved. In July, the participant applied for another withdrawal for mortgage payments. This was not approved because withdrawals are limited to two per plan year. Guess you can’t pay your mortgage out of your retirement plan account!
  • The participant wanted to “buy” her primary residence. Documentation was a statement from her current mortgage lender showing the amount owed on her current mortgage. Not approved.
  • Hardship request was for medical bills and documentation was a pile of credit card statements showing the bills were paid. Credit card debt does not qualify for hardship withdrawal. Request denied.
  • Participant applied for hardship to pay a son’s college expense. Collection notices for student loans to the son were provided as documentation. Most were from 2002 so the son is about 30 years old by now. First problem, to qualify, the expense has to be for the coming term – not for past expenses. Second, in my opinion, sacrificing your retirement plan for a kid’s education is silly – unless, of course, they promise to take care of you really, really well in your old age!
  • Here’s another one for college expense. A young man said he was going to take some classes at the local junior college. Documentation was a print out of a college homepage. Not quite good enough!

Being a Plan Sponsor is not easy, but it is worth the trouble to provide a really important benefit to your people. Maybe they sometimes get upset because they can’t treat their retirement plan like a savings account but, in the long run, they will thank you – maybe!