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George F. Bearup, J.D. Senior Legal Trust Advisor

1-Jul-20

Hardship Distributions v COVID-19 Distributions

Take-Away:  A hardship distribution from a qualified plan is not the same thing as a coronavirus-related distribution from a qualified plan. While there are some similarities, the requirements for each distribution is a bit different. This is probably also a timely reminder that there are no hardship distributions from an IRA; an IRA owner has access to their IRA balance at any time, and for any reason. An IRA owner can, however, if a qualified individual, take a coronavirus-related distribution from their IRA without incurring the 10% excise tax for an ‘early’ distribution.

Background: A coronavirus-related distribution can be taken from a 401(k) account, a 403(b) account, and a governmental 457(b) plan account. Such distributions can also be taken from an IRA. In order to be able to take a coronavirus-related distribution, the participant must meet the qualified individual definition as described in IRS Notice 2020-50.  If the participant is not a qualified individual, such a distribution is unavailable.

Plan Option Hurdle: For 2020 only, these retirement plans are permitted to offer coronavirus-related distributions, up to $100,000, as a new distributable event under the qualified plan. That is what a coronavirus-related distribution and a hardship distribution both have in common: if the qualified plan does not authorize and offer either a hardship distribution, or a coronavirus-related distribution, then neither distribution will not be available to the plan participant.

Hardship Distribution Hurdle: Assuming a qualified plan authorizes hardship distributions, the IRS imposes tough eligibility standards, since retirement savings are supposed to be held and later used for retirement income. For 401(k) and 403(b) account balances, a hardship withdrawal can be made only if it satisfies two conditions: (i) it is made on account of an immediate and heavy financial need of the employee;  and (ii) the distribution is necessary to satisfy the financial need. Interestingly, the standard for a hardship distribution from a 457(b) account is the more challenging unforeseen emergency.

Safe Harbor Hardship Distributions: The IRS has identified certain types of expenses that will automatically satisfy the immediate and heavy financial need requirement of a hardship distribution. A qualified plan can either adopt these ‘safe harbor’ expenses, or it can use a case-by-case approach to determine whether the employee-participant has an immediate and heavy financial need. In either of these situations, it is the employee-participant’s responsibility to document the needed expenses. Those safe harbor hardship expenses identified by the IRS include:

  • Purchase Principal Residence: This covers the costs related to the purchase of the residence for the participant, excluding mortgage payments;
  • Medical Expenses: This covers medical expenses for the participant, their spouse, their dependents, or the primary beneficiary designated under the qualified plan;
  • Prevent Eviction: This covers payments that are necessary to prevent an eviction from or foreclosure on a mortgage on the participant’s principal residence;
  • Education Expenses: This covers tuition, fees and room and board expenses for the next 12 months of post-secondary education for the participant, their spouse, child, dependent, or primary beneficiary designated under the qualified plan;
  • Funeral Expenses: This covers burial or funeral expenses for the participant, their spouse, child, dependent, or primary beneficiary designated under the qualified plan;
  • Principal Residence Expenses: This covers the repair for damages to the participant’s principal residence; and
  • FEMA Disaster Area: Last fall, the ‘safe harbor’ expense list was expanded by the IRS to cover expenses and losses incurred by the participant on account of a disaster area declared by FEMA, so long as the participant’s principal residence or principal place of employment at the time of the disaster was located in the FEMA designated disaster area. FEMA has declared all 50 states, Washington D.C. and four U.S. territories as disaster areas as a result of COVID-19.

Genuine Financial Necessity and Liquidity Hurdles: A hardship withdrawal can be made by a participant only if it is necessary to satisfy the financial need. As such, the amount requested as a financial hardship distribution cannot be more than the expense incurred by the participant. To meet this burden of proof, the participant must also demonstrate to the plan administrator that he/she has no other liquid assets available to pay the expense.

Hardship v Coronavirus-Related Distribution: It is possible that a participant can satisfy the safe harbor hardship distribution requirements for disaster related expenses and loses and also meet the definition of a qualified individual under the coronavirus-related distribution rules (if offered by the qualified plan.) In that case, it would be better for the participant to qualify under the coronavirus-related distribution rules since: (i) the amount distributed is not limited to the amount of ‘financial need’; (ii) other sources of liquidity are ignored; and (iii) less certification is required than for hardship withdrawals, meaning a much quicker determination of eligibility for the distribution.

In the event that the participant is not a qualified individual under the coronavirus-related distribution rules, but he/she does satisfy one of the safe harbor situations for a hardship distribution, he/she will still face a 10% early distribution penalty, and the full amount of the distribution will be subject to taxation in the year of the distribution (unlike the coronavirus-related distribution which is: (i) 10% penalty-free; (ii) the income tax on the distribution can be spread over three years; and (iii) can be repaid to the qualified plan in the next three years if the plan accepts rollovers.

Conclusion: Hardship distributions and coronavirus-related distributions are not the same. If a distribution is needed, it is best to try to qualify for a coronavirus-related distribution, if the qualified plan authorizes such distributions.