Sometimes, plan sponsors don’t follow the terms of their plan document when it comes to hardship distributions, and that can jeopardize the tax-qualified status of the plan. Here’s what the IRS says are some of the most common errors.
Making hardship distributions even though they aren’t permitted by the plan document
If a plan makes a hardship distribution, the plan document must contain the appropriate language to allow it. The IRS explains that plan sponsors may correct the operational failure of making hardship distributions to employees under a plan that doesn’t have hardship distribution language using the plan amendment correction method outlined here.
Allowing these distributions for reasons other than those stated in the plan document
If the plan language allows hardship distributions only under specific circumstances – well, the plan can only make hardship distributions in those circumstances. For example, the IRS explains that if the plan states hardships distributions can only be made to pay tuition, then the plan can’t permit a hardship distribution for any other reason, such as a home purchase. And, while the law permits hardships for funeral expenses, a plan can’t distribute funds unless it specifically lists these expenses as a stated reason for a hardship. If the plan sponsor wants to allow for a broader definition of hardship, they need to amend their plan.
Failing to suspend participant salary deferrals following a hardship distribution, if required by plan terms
If the plan requires that an employee to be suspended from contributing to the plan making the distribution and all other employer plans for at least six months after receiving a hardship distribution, then the plan must suspend salary deferrals.
The IRS notes that if the plan fails to do this, there are some correction options:
- Option 1 — Suspend the employee from making salary deferrals for a 6-month period going forward (though the IRS notes that this may not put the participant in the same position as they would’ve been if their contributions had been suspended immediately after receiving the hardship distribution. For example, the plan’s matching contribution levels for the 6-month period going forward could be different than what they were during the correct suspension period.
- Option 2 — Return the hardship distribution. The employee could return the hardship distribution (adjusted for earnings) to the plan. This could put the employee in the same position she would’ve been in had the failure not occurred, though it might not work if the affected employee is not able to afford that restoration. The IRS goes on to note that the plan sponsor can’t address a failure to suspend salary deferrals by simply revising administrative procedures going forward because this option wouldn't correct the failure to suspend elective deferrals in the past.
Said another way, the most common mistakes on hardship distributions seem to arise from simply not following the terms of the plan document.
