As employees see the balance of their 401(k)s grow, it can often be tempting for them to want to use the funds. Although it’s not required, some plans opt to provide employees with the opportunity of making a hardship or loan withdrawal from their 401(k). According to the New York Times:
“Over a quarter of households that use one of these plans take out money for purposes other than retirement expenses at some point. In 2010, 9.3 percent of households who save in this way paid a penalty to take money out. They pulled out $60 billion in the process; a significant chunk of the $294 billion in employee contributions and employer matches that went into the accounts.”
If you’re a business owner or HR manager in the midst of setting up a new 401(k) or just switching providers, and you’re considering including loan and hardship withdrawal options in your 401(k) plan, carefully consider the design and how you’ll administer those elements of the plan for your employees. You may find it difficult to balance employee’s immediate needs against their long-term financial security and administrative burden on the company.
Human Interest includes these options by default in our plan at no additional cost to the employer. Be sure to check with your 401(k) provider to see if there will an additional fee for adding them to your plan.
What is the definition of a “hardship withdrawal” from a retirement plan?
According to the IRS, a hardship withdrawal must be made based on the “immediate and heavy financial need” of the employee.
Immediate and heavy expenses may include:
- medical expenses
- costs related to the employee’s principal residence (e.g., purchase, prevention of eviction or foreclosure, repair of damages
- tuition and associated educational fees
- burial or funeral expenses
A plan is not required to provide for hardship distributions, and it may also define which hardships the withdrawal may be used to cover. For example, the play may allow it to be used to cover for funeral expenses, but not for payment of tuition. The criteria used to determine the hardship must be specified in the plan, and nondiscriminatory standards must be applied when reviewing and granting requests.
When a withdrawal is made before an employee is 59.5 years old, a 10 percent excise tax is imposed in addition to federal, state and local taxes on the withdrawal. Some employees may need to withdraw enough money to cover their hardship, as well as the taxes. Although employees are not required to pay the hardship withdrawal back, depending on the timing and the amount of money involved, early withdrawal of retirement funds can severely impact their long-term financial security.
What should employers consider before including hardship withdrawals in the 401(k) plan?
The IRS requires that plan administrators have enough information to assess and evaluate hardship requests. This means that employers and plan administrators (the person who runs the 401(k) at your company) must gather enough documentation to make an informed decision. Similarly, there must be a good system of record for keeping these documents on file. If an audit occurs, employers may be penalized if the necessary proof of the employee’s hardship (e.g., late fees, invoices, etc.) isn’t available.
With heightened concerns about “leakage” (i.e., early withdrawals) from retirement savings accounts for nonretirement purposes, it’s even more imperative that employers are on top of their records if they elect to include this as part of their 401(k) plan. It’s a nice option to offer your employees, but it requires significant attention to detail when it comes to documentation.
What about loans?
Just as with hardship withdrawals, retirement plans may offer loans, but an employer is not required to include this option as part of the 401(k) plan. If it is included, participants must apply for the loan and must meet certain requirements and be administered under the terms specified.
When an employee requests a loan from your plan, the IRS stipulates the following information should be provided:
- loans are/are not permitted
- minimum dollar amount required to obtain a loan
- maximum number of loans permitted by the plan
- maximum dollar amount permitted
- term of repayment (number of years)
- interest rate information
- security for the loan
- how repayment may be made (for instance, payroll deduction)
- spousal consent requirements
A note about interest rates: according to U.S. Department of Labor Regulations, the interest rate for a participant loan from a retirement plan must be reasonable and comparable to the current interest rates charged by financial institutions for similar loans. While interest rates vary by plan, the rate most often used is what is termed the “prime rate” plus one percent, in other words, the interest that will apply on the loan will be the rate as reflected in the Wall Street Journal on the date of the loan plus 1% per year.
Employees are required to repay these loans, and unlike the hardship withdrawal, they will not be taxed for the loan. One thing to keep in mind about 401(k) loans is that they are generally recommended as an absolute last resort in comparison to other types of loans: Why it Doesn’t Make Sense to Take a Loan from Your 401(k).
Key considerations regarding loans and hardship in your 401(k) plan
Before you decide to offer either or both of these options as part of your plan:
- Be sure you have the staff required to administer and process loan and withdrawal requests.
- If you include this as part of the plan, conduct regular audits to ensure that your records and process meet IRS guidelines.
- Analyze data or regularly do quick employee surveys (depending on the size of your company) to understand what percent of them foresee that they may take loans or make hardship withdrawals in the future.
- If the number of loan or withdrawal requests is increasing, provide employees with education about the impact that these withdrawals will have on retirement savings. While employers want employees to be able to handle immediate financial situations and needs, it’s also important that employees know what’s involved if they request a withdrawal or loan from their 401(k).
Of course, ultimately it’s the employee’s money, and it’s their decision to apply for a loan or make a hardship withdrawal from their 401(k). But when employees reach retirement age, they will truly appreciate their employer’s due diligence in informing them about the benefits and risks of removing funds from their investment to cover immediate needs.