Many plans allow participants to withdraw funds from the plan in the event the participant incurs a financial hardship. In order to qualify for a hardship withdrawal, the participant must demonstrate their financial need (the “needs test”) and demonstrate that they can’t obtain the funds to meet their financial need from another source (the “means test”).
There are two ways to demonstrate that a hardship meets the needs test. The first way is to limit hardship withdrawals to the 6 reasons allowed by the IRS. The second way is to have the plan’s administrative fiduciary make a decision based on the facts and circumstances of the participant’s situation.
There are two ways to meet the means test. In the first, the participant must take a plan loan if it is available prior to taking the withdrawal and suspend making 401(k) contributions for a period of at least 6 months. In the second, the participant must provide sufficient proof for the plan’s administrative fiduciary to determine that there are no other funds available such as participant loans, commercial loans, loans from a life insurance policy, bank account balances, etc.
As you can probably tell, satisfying the first of the two in each case, the safe harbor method, is easier for the plan’s administrative fiduciary since no discretion is needed. However, if you use the other options, you are in a facts and circumstances situation. It is critical that you document each decision and be consistent in your decision making.
The next hurdle is that the participant cannot ask for more than they need, plus an appropriate amount to cover the estimated taxes on the distribution. You must have documentation in your records, or of your service provider team must have such documentation, in order to demonstrate that the amount distributed to the participant was appropriate. The participant is not supposed to check a box on a website page that basically says “I certify that this is what I need” and that’s all. There should be some proof somewhere. The burden to obtain the proof will rest with you, the plan administrative fiduciary, unless you have outsourced it to someone else.
If you elect the safe harbor needs test, the participant must first take a loan if one is available from the plan. If that isn’t sufficient to meet the hardship, the participant can take the hardship withdrawal. However, you must suspend their 401(k) deferrals for a period of at least 6, and possibly as many as 12, months. Check your plan document or ask your service provider team. And don’t forget, at the end of the suspension period, you may have to restart the deferrals. You’ll need to monitor these suspension periods so you know when the participant can begin saving again.