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Frequent 401(k) Audit Finding Series - Hardship Distributions

Background

If elected by the Plan Sponsor, hardship distributions can be incorporated into the design of a 401(k) Plan.  For Plans that allow hardship distributions, IRS rules must be followed.  This includes determination that the participant has an immediate and heavy financial need.


Observations

The IRS safe harbor definition deems a distribution was made for immediate and heavy financial need if the distribution is for:

  1. Medical care expenses (employee and dependents)
  2. Tuition and related educational fees (employee and dependents)
  3. Funeral expenses (employee and dependents)
  4. Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments)
  5. Payments necessary to prevent eviction or foreclosure from principal residence
  6. Certain expenses to repair damage to employee’s principal residence

It is the responsibility of the Sponsor to limit the amount of the hardship distribution to the immediate need the participant can demonstrate (and any related taxes).  This is done by the Sponsor requesting documentation of expenses (medical invoices, eviction notices, tuition bills, etc.) prior to approving the distribution.  In addition, the IRS requires that employees suspend contributions to the 401(k) plan for a period of 6 months following a hardship distribution.


Failures

During a 401(k) audit, hardship distributions are a common area where failures are discovered.  We see instances where the Sponsor was unaware that they were required to gather supporting documentation, and they have approved the distribution without verifying that an immediate need existed.  Occasionally, we find employees who continue to contribute to the Plan during the 6-month suspension period. 


Corrective action

When a Sponsor has approved distributions without obtaining the necessary supporting documents, we recommend that the Sponsor work with the employee to retro-actively gather these documents.  If it is found that the distribution did not qualify, we would then recommend that the Sponsor work with the record keeper and/or their ERISA counsel to determine the appropriate corrective action.

If contributions have not been suspended, and the failure is found within a reasonable time, we recommend initiating a 6-month suspension when identified.   If a significant time has passed, you will need to review the options available in the IRS 401(k) Plan Fix-it Guide


Scott M Dufek, CPA | 07/09/2018




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