As the current economic difficulties continue to affect businesses and employees, many Firm clients will likely begin receiving inquiries from employees regarding their ability to obtain money from the company-sponsored 401(k) plan via a plan loan or a hardship withdrawal. To assist with these inquiries, management needs to understand the rules applicable to plan loans and hardship withdrawals.
Loans: 401(k) plans are permitted, but are not required to allow employees to take plan loans. Unlike hardship distributions, if the plan permits employees to obtain plan loans, the purpose of the loan or the employee’s ability to obtain a loan elsewhere is an irrelevant factor. Plans may provide for a minimum loan amount (i.e. $1,000). The maximum amount that a plan can permit as a loan is (1) the greater of $10,000 or 50% the employee’s vested account balance, or $50,000, whichever is less. An employee may have more than one outstanding loan from the plan at any one time. However, the new loan, when added to the outstanding balance of the employee’s other loan balances, cannot exceed the maximum amount.
The plan must specify procedures for obtaining a loan and its repayment terms. Generally, the employee must repay any loan (with interest) within five (5) years. However, if the loan is being taken to purchase a principal residence, the employee may be able to pay the loan back in more than five years. If a loan fails to satisfy the rules with respect to amount, duration and repayment terms, the loan will be considered in default and treated as a taxable distribution from the plan. The plan document and the IRS Employee Plans Compliance Resolution System (“EPCRS”) provide guidance on how to correct loan failures due to employee and employer error.
As long as the loan is repaid, it will not be considered taxable income to the employee. If the employee fails to repay the loan, the unpaid amount will be considered taxable income to the employee in the year that the employee failed to repay the loan.
Hardship Withdrawals: 401(k) plans are permitted, but are not required to permit hardship withdrawals. Generally, hardship withdrawals are only available for unforeseeable expenses that an employee is unable to pay using all other available resources, including assets of the employee’s spouse. For a 401(k) plan to provide a hardship withdrawal the employee must have an “immediate and heavy financial need” and the amount must be reasonably necessary to satisfy the need.
Although an “immediate and heavy financial need” is determined by facts and circumstances, the IRS regulations provide that certain expenses are deemed to be “immediate and heavy,” including: (1) certain medical expenses, (2) costs related to the purchase of a principal residence, (3) tuition and related educational fees and expenses, (4) payments necessary to prevent the eviction from, or foreclosure on, a principal residence, (5) burial or funeral expense, and (6) certain expenses for the repair of damage to the employee’s principal residence. Because plans may limit the circumstances for hardship withdrawals, plan sponsors should review the plan document for approved withdrawals.
Generally, the plan will specify what information the employee must provide to demonstrate a hardship. However, because most plans use the “deemed necessary” rules outlined above, inquiry into the employee’s financial status is not required.
After receiving a hardship withdrawal, the employee is prohibited from making elective contributions to the plan and all other plans maintained by the company for at least six months. The amount of the hardship withdrawal is included in the employee’s gross income. In addition, the employee may also be subject to an additional 10% tax on early distributions. Unlike plan loans, hardship withdrawals are not repaid to the plan, thereby permanently reducing the employee’s account balance.