In times of crisis or unforeseen circumstances, plan sponsors play a critical role in helping employees navigate financial challenges. One option available to employees facing financial hardships is the ability to make emergency withdrawals from their 401(k) retirement plans. In this blog, we explore what plan sponsors need to know about emergency 401(k) withdrawals and how they can support their employees during difficult times while remaining compliant.
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Importance of Emergency 401(k) Withdrawals
Emergency 401(k) withdrawals, also known as hardship withdrawals, provide a lifeline to employees facing immediate and severe financial hardships. These withdrawals allow employees to tap into their retirement savings to meet immediate needs. However, there is a limit on the withdrawal amount. On the date of the request, the employee may not exceed the total elective deferral minus any previous distributions from the employee elective deferral source.
Emergency 401(k) Withdrawal Eligibility
Emergency 401(k) withdrawals are an optional provision to add to a plan. However, if you do decide to offer them to participants, you’ll want to be able to identify what constitutes an emergency. According to the IRS, 401(k) hardship withdrawals require employees to demonstrate an “immediate and heavy” financial need that cannot be met through other means. Qualifying withdrawals include:
- Health care expenses for the plan participant, their spouse, or a dependent
- Funeral expenses for the plan participant’s spouse or a dependent
- Purchase or repairs to a principal residence
- Payments to prevent eviction
- Tuition and room and board for the plan participants, their spouse, or a dependent
- Expenses resulting from a declared disaster
Documentation Regarding Emergency 401(k) Withdrawals
Another factor you’ll want to consider for emergency 401(k) withdrawals is documentation. This is because documentation proving the financial needs not only ensures compliance with IRS audits, but prevents abuse of the system as participants should not have access to the following resources if they are requesting an emergency 401(k) withdrawal:
- Discontinuation of elective deferrals
- Distributions that may be available from other plans
- A loan from the plan or a financial institution
- Reimbursement from an insurance company
- Other assets that may be liquidated.
Documents you’ll want the participant to provide include:
- Statement regarding the emergency and expenses related to it
- Receipts or invoices
- Title insurance documents
- Certification that the information is accurate
Tax Implications and Penalties
When employees make emergency withdrawals from their 401k plans, it is important to inform them about the potential tax implications. Typically, these withdrawals are subject to ordinary income tax. Additionally, if employees are below the age of 59 ½, they may also be subject to an early withdrawal penalty of 10%.
Important Plan Sponsor Note: Participants must be suspended from making further contributions for a minimum of six-months to meet with IRS compliance.
However, there are exceptions to these rules. If the plan owner dies, becomes totally and permanently disabled, or if the withdrawal is used to pay off unreimbursed medical expenses when the amount exceeds a percentage of the participant’s adjusted gross income, then it does not apply. Additionally, with the SECURE Act of 2019, the government waived withdrawal penalties for distributions up to $100,000 from retirement plans if it went to expenses related to qualified, federally declared disasters.
California Pensions: Here to Help
At California Pensions, our mission is to provide timely, high-quality support to retirement plan sponsors. We understand the importance of personalized service and direct communication and strive to make the jobs of retirement plan sponsors easier by providing superior consulting, administration, and recordkeeping services. Contact us today to learn more about how we can help you navigate the complexities of retirement planning and provide tailored retirement plan design and administration services to suit your unique needs.
