IRS Examination Agents continue to find errors in how Plan Administrators apply the hardship distribution rules in their Plans. The IRS has compiled Hardship Distributions Tips based on employee plans examination results to assist Plans with compliance.

Common Hardship Distribution Errors

When the IRS examines employee plans, the following are the most frequently encountered mistakes related to hardship distributions:

1. Hardship Distributions Permitted When Not Allowed
   In some cases, participants were granted hardship distributions, but the Plan Document did not actually allow for this type of distribution.

2. Hardship Distributions Made for Unauthorized Reasons
   Hardship distributions were made for reasons not specifically outlined in the Plan Document. The IRS requires that the specific criteria for hardship distributions be followed exactly as stated in the Plan.

By identifying these common errors, Plan Sponsors can:

• Review their Plan’s procedures and ensure compliance.
• Correct any existing issues and reduce the likelihood of these errors being discovered during an IRS audit.

If your Plan has made incorrect hardship distributions, refer to previous sections in the 401(k) Rescue for correction methods and guidelines.

Hardship Distribution Tips for Compliance

To avoid the above common errors and ensure your Plan remains compliant with IRS regulations, follow these key tips:

1. Review the Plan Document
   Thoroughly review the Plan Document to confirm:

   • Whether hardship distributions are permitted.
   • The definition of a hardship and the specific reasons for which they are allowed.
   • The procedures that both employees and employers must follow when requesting a hardship distribution.
   • The limits on the amount and type of funds that can be distributed for hardship purposes.
   • Note: As of 2020, plans may allow hardship distributions from elective deferral earnings, QNECs, QMACs, and safe harbor contributions. Check whether these sources are included in your plan document.

2. Strict Adherence to Plan Provisions
   Ensure that the Plan’s provisions regarding hardship distributions are strictly followed. Plans cannot be liberal in their interpretation of the criteria. Every step and requirement outlined in the Plan Document must be met.

3. Correct Errors Using EPCRS
   If hardship distributions have been made incorrectly (e.g., when not permitted by the Plan or for unauthorized reasons), correction may be made through the Self-Correction Program (SCP) under Rev. Proc. 2021-30, provided the plan has established operational compliance practices and is not under IRS examination. In some cases, a retroactive amendment may be appropriate.

4. Maintain Detailed Documentation
   Keep detailed records of all procedures and criteria used when granting hardship distributions. This includes records of each employee’s eligibility for a hardship distribution and the reasoning behind the distribution. Well-organized records will make it easier to demonstrate compliance during an IRS audit. Supporting documentation should include the participant’s hardship request, documentation of the financial need, approval process, and calculation of the distributed amount.

5. Distributions Must Be Based on Immediate and Heavy Need
   Remember that hardship distributions can only be made to address an immediate and heavy financial need. The amount distributed must not exceed what is necessary to meet the need, and there should be no other reasonably available resource that could meet the employee’s needs. As of 2020, the requirement to suspend elective deferrals after a hardship distribution has been eliminated. Plans may not impose suspension periods on participants receiving hardship distributions.

IRS Agent Examination

When the IRS Agent conducts an examination of the Plan’s hardship distributions, the main focus will be to verify that:

• The hardship distributions were made according to the Plan Document.
• The distributions were consistent with the law and regulatory requirements.

During an examination, the IRS will look at:

• Whether the Plan’s hardship procedures were followed.
• Whether sufficient records are available to support the hardship distribution decisions.

A well-organized system of internal controls and complete hardship distribution records will significantly improve the efficiency of the examination and can help demonstrate that the Plan is in compliance.

By proactively reviewing the Plan Document, adhering to the specified procedures, and keeping comprehensive records, Plan Sponsors can avoid common hardship distribution errors and ensure compliance with IRS rules.

For Assistance with Hardship Distribution Errors

If you need help correcting a hardship distribution error, contact Ekon Benefits at (314) 367-6555 or info@ekonbenefits.com.

Straight From the Source

Hardship Distribution Tips from EP Exams. Internal Revenue Service. https://www.irs.gov/retirement-plans/hardship-distribution-tips-from-ep-exam