Retirement Plan Enhancements: Hardship Withdrawals and Loans

Between the February budget law and the tax reform act of last December, certain 403(b) and 401(k) plan hardship distribution and loan rules have been eased. These changes will increase participants’ flexibility around accessing funds and returning money to their accounts. Additionally, employer-sponsors may welcome the removal of specific restrictions, one of which has triggered several employer plans to inadvertently fall into noncompliance.

Note that these plan design changes are optional and some plans simply do not allow loans or hardship withdrawals. Either way, best practice dictates that employers make a concerted effort to educate participants as to the impact that taking a loan, or a hardship withdrawal, has on their ultimate financial comfort in retirement. Clear communications on these items, as well as basic financial education, is the most helpful method to encourage employees to adequately prepare for retirement.

The information below highlights three changes to hardship withdrawals and one plan loan repayment update.

Hardship Withdrawals:

  • Beginning in 2019, a participant who takes a hardship withdrawal may continue making deferral contributions in spite of the withdrawal. Currently, plans are prohibited from accepting contributions from a participant for six months from the date of the hardship withdrawal. Consequently, it is the employer who must suspend the employee deferral in payroll processing and then trigger a reinstatement of the payroll deferral six months later. It is not uncommon for employers to fail to end such deferrals after a hardship distribution was given, or to fail to reinstate the employee’s deferral after the six months have lapsed. This is one of those simple oversights that can snowball into larger problems unless caught and corrected.
  • Presumably, the six-month restriction was intended to deter the taking of hardship withdrawals, so that the funds saved remain in the plan until retirement. But when there is a true hardship, this rule is perceived as hurting the very employee who experienced the hardship in the first place. Not only does the person lose six months of their own savings, but often the same employee also loses the employer’s matching contributions for those six months. This restriction, intended to deter, effectively decreases the individual’s future contributions by one-half (50 percent) during the subsequent twelve months.
  • Another change allows participants to withdraw money from more account sources than previously allowed. Effective in 2019, employees may take loans not only from their own contributions, but also from employer deposits, such as qualified matching, profit sharing and qualified non-elective employer contributions, as well as earnings on all sources. Note that the existing dollar amount and percentage loan maximums remain unchanged.
  • The third enhancement removes the mandate that participants seek loans from all available sources prior to requesting a hardship withdrawal. The upside is that one who has a serious financial need may not be able to manage loan repayments. The downside is the ordinary income tax, as well as the 10 percent penalty tax for those under age 59 ½, which comes with a hardship withdrawal.
  • Employers should anticipate and, if appropriate, prepare for the hardship withdrawal changes effective the first day of the plan year after December 31, 2018. This allows the IRS time to publish implementation guidance and respond to questions.

Employee Termination with Plan Loan Balance

  • Plan sponsors require employees who terminate employment with an outstanding plan loan balance to repay the loan in full within a grace period. This is sometimes up to 90 days from termination. If the loan is not fully repaid, the employer converts the outstanding amount to a defaulted distribution and must report it to the IRS as taxable income. Again, this triggers an additional 10 percent penalty for those under age 59 1/2.
  • As of 2018, a terminating employee has the option to avoid or reduce tax consequences by depositing the outstanding balance, or even a portion of this balance, into an individual IRA or into their new employer’s plan. From a tax perspective, this “payoff” is treated as a rollover. Further, there is no longer a 90-day time limitation to avoid tax consequences. Effective this year, the individual has until the due date (including extensions) for filing the federal income tax return for the year in which the loan is treated as a distribution.

Employer’s Council will update you as guidance is released. If you wish to address these or other enhancements to your employer plan(s), or if you have other design or compliance matters to address, note that Employers Council now offers ERISA and Benefit Consulting services to members only on a reasonable for-fee basis.