Hardship Distributions in a 401(k) Plan

Common Plan Mistakes – Hardship Distributions in a 401(k) Plan
The Problem

A 401(k) plan permits participants to receive hardship distributions. The distributions, however, do not satisfy the plan provisions relating to hardship distributions.

Example: George is the 100% owner of the George Company. The company sponsors a 401(k) plan which provides that a participant may take a distribution on account of hardship. The plan document requires that a participant may only receive a hardship distribution for the following reasons:

(1) to purchase a principal residence;
(2) to prevent eviction from, or foreclosure on, the principal residence;
(3) to pay certain medical expenses incurred by the participant, participant’s spouse, or dependents; and
(4) to pay certain educational expenses incurred by the participant, participant’s spouse, or dependents.

In addition, the plan document requires that the participant use all other sources of financing including proceeds from insurance, liquidation of other assets, and loans from other commercial sources before applying for a hardship distribution. Jim, a plan participant, asked for and received a hardship distribution of $20,000 from the plan. He did not provide a reason for the distribution and did not establish that he had used other sources of financing before applying for the hardship distribution.

Finding the Mistake

In order to find the mistake, review:

(a) the plan document to determine when distributions may occur;
(b) each plan distribution and its related documentation showing the reason for the distribution (e.g., distribution form signed by the participant indicating the reason for the distribution); and
(c) whether distributions designated as “hardship distributions” were made in accordance with the terms of the plan.

In the example above, Jim did not complete any distribution forms. The only documentation in the file was a note requesting a hardship distribution for $20,000. It was found that Jim used the money to buy a car. There was no evidence that he investigated other sources of financing.

This was an isolated instance. For each of the other hardship distribution requests, the participant was required to complete a distribution form. The distribution form required the participant to specify the purpose for the distribution (e.g., medical expense, education expense, purchase of residence) and to certify that other sources of financing (including insurance proceeds, disposition of other assets, or other loans) were not available to the participant. The distribution form was then submitted to the employer’s accountant, who evaluated the form before approving the hardship distribution to the participant. When Jim applied for a distribution, however, he went directly to George, who authorized payment without requiring Jim to complete the distribution form. Also, George was not familiar with the terms of the plan. As a result, he approved a distribution that did not comply with those terms.

Fixing the Mistake

The company should take reasonable steps to ensure that Jim returns the erroneously distributed amounts to the plan. Jim should also be advised that to the extent any amounts are not returned, they are not eligible for tax favored treatment (i.e., the amounts are not eligible for rollover to an IRA or other retirement plan). In addition, the plan’s administrative procedures should be revised to ensure that the error does not occur again. (See “Avoiding the Mistake” below.)

Correction Program(s) Available

The plan may use the correction programs described in Revenue Procedure 2006-27 to correct the mistake. If the plan is not the subject of an IRS examination, then the plan will generally be able to correct the mistake using either the Self-Correction Program (SCP) or the Voluntary Correction Program (VCP). If the plan is under IRS examination, then mistakes are generally corrected pursuant to a closing agreement under the Audit Closing Agreement Program (Audit CAP). However, if the mistake is an isolated instance (as is the case in this example), the mistake may still be eligible for correction under SCP.

Avoiding the Mistake

George should be familiar with the terms of the plan. A formal approval process had been installed to ensure that hardship distributions comply with the terms of the plan, including documenting the reason for the hardship and certification of the unavailability of other sources of money. George should be aware of the purpose of such a process, and understand the risks of approving distributions without following it. George should not approve distributions based on verbal or informal written requests, but instead, should follow the formal approval process before authorizing a hardship distribution. For more details on how to find, fix, and avoid this mistake, you may also refer to the online 401(k) Fix-It Guide.

We offer solutions to tax problems. Contact our firm today and speak directly with Mike Habib at 1-877-78-TAXES, 1-877-788-2937, or online at myirstaxrelief.com

Client Reviews
★★★★★
Mike has given us peace of mind! He helped negotiate down a large balance and get us on a payment plan that we can afford with no worries! The stress of dealing with the IRS is huge and Mike helped us through it all. The peace of mind is invaluable, thank you Mike!April S.
★★★★★
Mike Habib - Thank you for being so professional and honest and taking care of my brothers IRS situation. We are so relieved it is over and the offer in compromise process went just as you said. Mike is very professional and will give you honest answers to the OIC process and you can really trust him. You won't be sorry you chose him!Joe and Deborah V.
★★★★★
Mike is a true professional. He really came thru for me and my business. Dealing with the IRS is very scary. I'm a small business person who works hard and Mike helped me see that they are not that scary after all. He was always there with the answers I needed and was very good about calling me back which I appreciated since your first reaction is to freak out and ask a million questions. He solved a messy case and worked very hard to resolve it. His rates are VERY reasonable for the amount of work he does! I give him my highest recommendation!Marcie R.
★★★★★
Mike was incredibly responsive to my IRS issues. Once I decided to go with him (after interviewing numerous other tax professionals), he got on the phone with the IRS immediately (as in the same day I signed with him) to squash an impending issue. And he worked directly with them to quickly come to a resolution I am very happy with. I'd highly recommend reaching out to Mike to see if he can help you with any IRS issues. I'm very satisfied!Marshall W.
★★★★★
I’ve seen and heard plenty of commercials on TV and radio for businesses offering tax help. I did my research on many of them only to discover numerous complaints and unresolved tax issues. I found Mike Habib through my own online search and contacted him. He was very professional with great communication, always answering my questions and concerns. Mike resolved my complicated tax problem just as he said he would. I would definitely recommend his services to family and friends.Nancy & Sal V.

BBB Accredited Business
Trust Link
California Society of Enrolled Agents
NAEA
NATP
Enrolled Agent