Hardship and Leakage: New IRS Rules May Have Employees Asking Tough Questions

These new rules may have employees asking questions. While most of those questions might involve how to get access to their accounts, some employees may have bigger questions about whether to prioritize savings over retirement.

69% of Americans have less than $1000 in savings. That’s more than two-thirds of the population. It’s concerning how little Americans have saved towards emergencies. It’s even more concerning given the average household’s credit card debt. The average credit card debt per U.S. household for balance-carrying households in December of 2019 is $9,333, up $1000 since June of 2019. Households with the lowest net worth (zero or negative) hold an average of $10,308 in credit card debt. And those with the highest net worth $500,000 or higher, held approximately $8,000 in debt. If Americans are using credit cards to cover emergencies, like medical deductibles and other difficulties, then easing access to 401(k) funds to cover emergencies may be helpful to those who need the most help.

Recently, the Internal Revenue Service (“IRS”) and the Treasury Department issued new rules that could allow employees to withdraw funds from their 401(k), 403(b) and 457(b) plan accounts in the case of hardship. While the existing rules have allowed employees to withdraw funds for limited circumstances, the new rules have expanded the concept of hardship to allow for more withdrawals.

These new rules may have employees asking questions. While most of those questions might involve how to get access to their accounts, some employees may have bigger questions about whether to prioritize savings over retirement.  

While many, but not all 401(k) plans allow for hardship withdrawals, recent surveys show that about 80% of plans allow them, employees may not know if their plan is among the 20% that don’t allow them. Many employees may not know that not all 401(k) plans have hardship distributions. The allowance for them is permissive not mandatory – meaning that IRS rules allow 401(k) plans to permit employees to withdraw funds if they meet the requirements. The definition of what constitutes hardship is set by the plan. According to the IRS, the plan “must provide the specific criteria used to make the determination of hardship…. In determining the existence of a need and of the amount necessary to meet the need, the plan must specify and apply nondiscriminatory and objective standards.” These rules are similar for 403(b) plans. However, 457(b) plans that wish to allow hardship withdrawals must contain specific language defining what constitutes a distribution on account of an "unforeseeable emergency."

More specifically for the need to meet the IRS’s definition of hardship, the need must be “on account of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need. The need of the employee includes the need of the employee's spouse or dependent.”

The new rules from IRS and Treasury, enacted in 2018 as part of the Bipartisan Budget Act of 2018 and coming into force in January of 2020 have a few salient impacts. Three that stand out are, first, the repeal of the 6 month suspension of elective deferrals after having received a hardship distribution. Second, removing the requirement to first take a loan from the plan before requesting a hardship. Third, allowing hardship distributions to plan participants for repairs on a primary residence even if the repair is not for a casualty loss.

Hardship withdrawals are disfavored in general. Estimates show that these withdrawals, also known as leakage amount for about 1.5% of assets leaving 401(k) plans which has the effect of reducing assets for those under age 60 to almost 20%.

As to the first change, some analysts think that the changes to the hardship withdrawal rules may encourage more Americans to start saving for retirement. Previously, an employee who made a hardship withdrawal wasn’t permitted to begin contributing to the account again for up to 6 months. The effect of that waiting period could mean that employees couldn’t replenish the amount they withdrew. Allowing employees to have access to the retirement accounts may help those who feel that they are stuck between saving for emergencies and saving for retirement. Ideally, employees need to have both accounts robustly stocked. But having the option to withdraw, as a “safety valve” may encourage employees who don’t currently have an account to start one.

As to the second change noted above, removing the requirement to exhaust the loan option from a 401(k) plan before allowing a hardship distribution may help employees who will not be able to repay the loan and may face penalties on the distribution – which could cause them to take a larger distribution to account for the penalties.

Finally, allowing participants to take a distribution for a repair to a primary residence may allow those plan participants to ready their house for sale. The impact of that could be to free up equity in their homes to meet additional challenges or to move to a residence with a lower mortgage. Each of these three changes could have the impact of allowing plan participants to meet emergencies without having to use credit for emergencies.

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