The Pros and Cons of Hardship Distributions to Participants

by Stacey L. Spencer, QKA | Manager, Employee Benefit Services Group

In my last article, I discussed the burden of proof on the plan sponsor to assure a hardship request meets the IRS criteria. In this piece, we will look at the pros and cons of taking hardship distribution from the participant’s perspective.

As a reminder, a hardship distribution allows emergency access to one’s retirement account balance. 401(k) plans, 403(b) plans, and 457(b) plans may permit hardship distributions. Hardship distributions are only allowed for an immediate and heavy financial need, and are limited to the amount necessary to satisfy that financial need.

PROS:

• The advantage of taking a hardship distribution is pretty obvious; participants are allowed to withdraw money from their retirement plan to cover a financial hardship.
• If the forms and backup documentation are provided without delay, then the funds can be in the participant’s hands in short period of time.
• Employees may have access to funds in their accounts for legitimate purposes, such as a down payment on a house, college tuition or to pay medical expenses not covered by insurance.

CONS:

• The amount withdrawn cannot be repaid to the plan. So if the participant’s financial situation changes, they cannot put the money back into the plan.
• Participants who take a hardship distribution are required to suspend deferrals for six months afterwards. If there is an employer match, they miss out on those contributions during the suspension period.
• Because the hardship distribution is not a loan, it is subject to ordinary income taxes. The participant will have to report the hardship distribution as taxable income in the year of distribution. If the participant is under the age of 59, they may also be required to pay a 10% early distribution penalty in addition to the income taxes.
• Loss of compounding interest on the amount of the hardship distribution. This is one of the most detrimental consequences of taking a hardship distribution and it is something that participants often do not consider.

Participants should consult with a tax advisor and carefully consider all options and the ramifications of taking a hardship distribution. In most cases, the long term disadvantages of taking a hardship distribution far outweigh the advantages.