BY PHIL GOLDSTEIN
Managing Partner, Goldstein, Lieberman & Co.
Most 401(k) plans permit hardship withdrawals, though plan sponsors aren’t required to allow them. Currently employees seeking to take money out of their 401(k) accounts are limited to the funds they contributed to the accounts themselves, and only after they’ve first taken a loan from the same account. Loans must be repaid. The theory behind the loan requirement is that employees would be less apt to permanently deplete their 401(k) accounts with hardship withdrawals.
Due to the Bipartisan Budget Act (BBA), the rules change, beginning in 2019. Under the BBA, the employees’ withdrawal limit will include not just amounts they have contributed. It also includes accumulated employer matching contributions plus earnings on contributions. If an employee has been participating in your 401(k) for several years, this modification could add substantially to the amount of funds available for withdrawal in the event of a legitimate hardship.
Liberalized Participation Rule
The BBA also eliminates the current six-month ban on employee participation in the 401(k) plan following a hardship withdrawal. This is good news: Employees can stay in the plan and keep contributing, which allows them to begin recouping withdrawn amounts right away. And for plan sponsors, they won’t be required to dis-enroll and then re-enroll employees after that six-month hiatus.
One thing that hasn’t changed: Hardship withdrawals are subject to a 10% tax penalty, along with regular income tax. That combination could take a substantial bite out of the amount withdrawn, effectively forcing account holders to take out more dollars than they otherwise would have in order to wind up with the same net amount.
The BBA also didn’t change the reasons for which hardship withdrawals can be made. Here’s a reminder of the criteria, as described by the IRS: Such a withdrawal “must be made because of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need.” That can include the need of an employee’s spouse or dependent, as well as that of a non-spouse, non-dependent beneficiary.
The IRS goes on to say that the meaning of “immediate and heavy” depends on the facts of the situation. It also assumes the employee doesn’t have any other way to meet the needs apart from a hardship withdrawal. However, the following are examples offered by the IRS:
- Qualified medical expenses (which presumably don’t include cosmetic surgery);
- Costs relating to the purchase of a principal residence;
- Tuition and related educational fees and expenses;
- Payments necessary to prevent eviction from, or foreclosure on, a principal residence;
- Burial or funeral expenses; and
- Certain expenses for the repair of damage to the employee’s principal residence.
Another important and somewhat related change in 401(k) rules was included in the 2017 Tax Cuts and Jobs Act (TCJA) that took effect this year; it pertains to plan loans. Specifically, prior to 2018, if an employee with an outstanding plan loan left your company, that individual would have to repay the loan within 60 days to avoid having it deemed as a taxable distribution (and subject to a 10% premature distribution penalty for employees under age 59-1/2).
The TCJA changed that deadline to the latest date the former employee can file his or her tax return for the tax year in which the loan amount would otherwise be treated as a plan distribution. So, for example, if an employee with an outstanding loan of $5,000 left your company and took a new job on Dec. 31, 2017, that individual would have until April 15 (or, with a six-month fling extension, Oct. 15) 2018 to repay the loan.
Alternatively, the former employee could make a contribution of the same amount owed ($5,000, in this example) to an IRA or the former employee’s new employer’s plan, assuming the new plan permitted it. In effect, that $5,000 contribution to a new plan would be treated the same as a rollover from the old plan.
As always, please consult your tax advisor should you have any questions.