Now That It’s a Rainy Day: Calling in the Emergency Funds and Changing Hardship Definitions

Which ever set of rules a Plan Sponsor may have been considering adopting to provide employees with more options, now may be the time to consider broadening the possibilities available to employees. In these rainy days, shelter of any kind may be welcomed.

In the Spring of 2020, many employees are facing surprising economic hardships due to a global pandemic. While relief may be on the way for some employees facing financial hardship due to work stoppages related to the pandemic, those who rely on income from small businesses, retail or consulting work may not see that relief. Employees may live in households where one of the incomes was reduced for a significant period of time. In short, if families were saving for a rainy day, that day may have come. Plan Sponsors readying to change the hardship rules in their plan documents, or who may have recently done so, may want to consider how they can assist their employees during this time.

Its worth noting that most families don’t have enough in their rainy day funds. According to the New York Times “To cushion against a simultaneous spike in expenses and dip in income, a middle-income family needs about $5,000 in a rainy-day fund but has just $2,000 — a gap of $3,000. Lower-income families need about $2,500 but have just $700.” And according to the AARP, more than half of American households lack an emergency savings account. And worse, according to the Kaiser Family Foundation, 82% of employees with health care have a deductible with an average of $1,655. In other words, most family’s rainy day fund just covers the deductible on their health care funds. We have also covered how Plan Sponsors can help employees plan for the unexpected. It may now be time for Plan Sponsors to help employees use those plans.

For employees without an emergency fund, they may want to review rules on how they can borrow from their 401(k) plans. Loans from 401(k)s are disfavored, but in some circumstances may be better than relying on credit cards or missing mortgage payments due to a family budget shortfall. We’ve written about that in other articles before, but it bears repeating that employees who leave or are terminated from their jobs must repay the balance of their loan within 60 days to avoid having the amount they withdrew treated as a taxable distribution. The Secure Act allows for loans from a 401(k) for the birth or adoption of a child, which may be something an employee may be struggling with planning for now that it is a rainy day.

We have also written before that withdrawals from 401(k)s that meet certain requirements, known as hardship withdrawals may have different tax treatment. Those circumstances are usually in plan documents, but do not always fall into a safe harbor for IRS treatment. Repayment requirements can be tough, and the IRS may sanction any missed payment with disfavorable tax treatment, such as by considering the remaining balance on a loan from a 401(k) as a distribution and therefore treat it as income for tax purposes.  

Plan Sponsors can change the plan documents to incorporate a broader hardship definition, but should only do so after speaking with their legal counsel. Most Plan Sponsors, nearly 64% have already embraced the new hardship rules that went into effect in 2018 and still more that went into effect in 2019. Those rules reduced penalties for taking a hardship withdrawal and eliminated a six-month prohibition on contributions following a hardship distribution, among other things. Broadening the hardship definition may still be an available action for some Plan Sponsors whether they chose to change in 2018 or not. If they haven’t yet done so, Plan Sponsors can now allow employees to withdraw funds first, instead of taking a loan, and may also allow employees to withdraw qualified employer contributions which previously were forbidden. Which ever set of rules a Plan Sponsor may have been considering adopting to provide employees with more options, now may be the time to consider broadening the possibilities available to employees.

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