While it probably seems odd that there is a connection between the government passing a budget and your 401(k) plan, this year there was. On February 9, 2018, the Bipartisan Budget Act of 2018 was passed into law which ended the government shutdown by raising the debt ceiling for the next two years. However, also buried in the new law were changes to rules that govern hardship distributions in 401(k) plans.
What Is A Hardship Distribution?
A hardship distribution is an optional distribution feature within a 401(k) plan. In other words, your 401(k) plan may or may not allow them. To answer that question, you will have to reference the plan’s Summary Plan Description (SPD) which should be readily available to plan participants.
If your plan allows hardship distributions, they are one of the few in-service distribution options available to employees that are still working for the company. There are traditional in-service distributions which allow employees to take all or a portion of their account balance after reaching the age 59½. By contrast, hardship distributions are for employees that have experienced a “financial hardship”, are still employed by the company, and they are typically under the age of 59½.
Meeting The “Hardship” Requirement
First, you have to determine if your financial need qualifies as a “hardship”. They typically include:
- Unreimbursed medical expenses for you, your spouse, or dependents
- Purchase of an employee’s principal residence
- Payment of college tuition and relative education costs such as room and board for the next 12 months for you, your spouse, dependents, or children who are no longer dependents.
- Payment necessary to prevent eviction of you from your home, or foreclosure on the mortgage of your primary residence
- For funeral expenses
- Certain expenses for the repair of damage to the employee’s principal residence
Second, there are rules that govern how much you can take out of the plan in the form of a hardship distribution and restrictions that are put in place after the hardship distribution is taken. Below is a list of the rules under the current law:
- The withdrawal must not exceed the amount needed by you
- You must first obtain all other distribution and loan options available in the plan
- You cannot contribute to the 401(k) plan for six months following the withdrawal
- Growth and investment gains are not eligible for distribution from specific sources
Changes To The Rules Starting In 2019
Plan sponsors need to be aware that starting in 2019 some of the rules surrounding hardship distributions are going to change in conjunction with the passing of the Budget Act of 2018. The reasons for taking a hardship distribution did not change. However, there were changes made to the rules associated with taking a hardship distribution starting in 2019. More specifically, of the four rules listed above, only one will remain.
No More “6 Month Rule”
The Bipartisan Budget Act of 2018 eliminated the rule that prevents employees from making 401(k) contributions until 6 months after the date the hardship distribution was issued. The purpose of the 6 month wait was to deter employees from taking a hardship distribution. In addition, for employees that had to take a hardship it was a silent way of implying that “if things are bad enough financially that you have to take a distribution from your retirement account, you probably should not be making contributions to your 401(k) plan for the next few months.”
However, for employees that are covered by a 401(k) plan that offers an employer matching contribution, not being able to defer in the plan for 6 months also meant no employer matching contribution during that 6 month probationary period. Starting in 2019, employees will no longer have to worry about that limitation.
Loan First Rule Eliminated
Under the current 401(k) rules, if loans are available in the 401(k) plan, the plan participant was required to take the maximum loan amount before qualifying for a hardship distribution. That is no longer a requirement under the new law.
We are actually happy to see this requirement go away. It never really made sense to us. If you have an employee, who’s primary residence is going into foreclosure, why would you make them take a loan which then requires loan payments to be made via deductions from their paycheck? Doesn’t that put them in a worse financial position? Most of the time when a plan participant qualifies for a hardship, they need the money as soon as possible and having to go through the loan process first can delay the receipt of the money needed to remedy their financial hardship.
Earnings Are Now On The Table
Under the current 401(k) rules, if an employee requests a hardship distribution, the portion of their elective deferral source attributed to investment earnings was not eligible for withdrawal. Effective 2019, that rule has also changed. Both contributions and earnings will be eligible for a hardship withdrawal.
Still A Last Resort
We often refer to hardship distributions as the “option of last resort”. This is due to the taxes and penalties that are incurred in conjunction with hardship distributions. Unlike a 401(k) loan which does not trigger immediate taxation, hardship distributions are a taxable event. To make matters worse, if you are under the age of 59½, you are also subject to the 10% early withdrawal penalty.
For example, if you are under the age of 59½ and you take a $20,000 hardship distribution to make the down payment on a house, you will incur taxes and the 10% penalty on the $20,000 withdrawal. Let’s assume you are in the 24% federal tax bracket and 7% state tax bracket. That $20,000 distribution just cost you $8,200 in taxes.
Gross Distribution: $20,000
Fed Tax (24%): ($4,800)
State Tax (7%): ($1,400)
10% Penalty: ($2,000)
Net Amount: $11,800
There is also an opportunity cost for taking that money out of your retirement account. For example, let’s assume you are 30 years old and plan to retire at age 65. If you assume an 8% annual rate of return on your 401(K) investment that $20,000 really cost you $295,707. That’s what the $20,000 would have been worth, 35 years from now, compounded at 8% per year.
Plan Amendment Required
These changes to the hardship distribution rule will not be automatic. The plan sponsor of the 401(k) will need to amend the plan document to adopt these new rules otherwise the old hardship distribution rules will still apply. We recommend that companies reach out to their 401(k) providers to determine whether or not amending the plan to adopt the new hardship distribution rules makes sense for the company and your employees.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.