Hardship Distributions – Correcting Failure to Suspend Deferrals

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By Stacey L. Spencer, QKA, Manager, Employee Benefit Services | Tim Ayler, CPA, Partner, Director Employee Benefit Services Group

Continuing the discussion of hardship distributions, one of the requirements of a hardship distribution is that upon receipt of a hardship distribution from a 401(k) plan (or 403(b) or 457(b) plan), the employee is prohibited from making elective contributions to the plan and all other plans maintained by the employer for at least six months. Whether deferrals may resume automatically, or only upon participant election, will be indicated in the plan document.

Failure to suspend a participant’s elective deferrals following hardship withdrawal distribution for six months is a common error that occurs in plan administration. This oversight must be corrected for the plan to remain in compliance with IRS regulations.

Although the IRS has never provided a written procedure to correct the failure to suspend deferrals, they have provided guidance in presentations. There are two options to correct under the IRS Employee Plans Compliance Resolution System (EPCRS):

Option 1 – Return the improper elective deferrals (adjusted for earnings) to the employee. This puts the participant in the same position he or she would have been had the failure not occurred.

Option 2 – Suspend the elective deferrals for a six-month period going forward. This solution is not as good as Option 1. It may not return the participants to the same position.

Taking no action and simply revising the administrative procedures does not correct the failure and exposes the plan to possible penalties and even disqualification.

Hardship distributions have increased in frequency due to the poor economy. This error is relatively easy to fix, but it is best to avoid altogether. The key to avoiding the error is proper administrative procedures. There must be a procedure to notify payroll that the hardship has occurred and the deferral suspension must begin.

If you would like assistance regarding correction of failure to suspend deferrals following a hardship, please contact Stacey L. Spencer at 317-260-4421 or sspencer@greenwaltcpas.com.