(Updated Dec. 4, 2009)
When facing financial difficulties, employees often look to their retirement plans as a possible source of needed funds. Many plans offer participant loans or permanent withdrawals, the latter generally on a hardship basis. However, plan loans and withdrawals can jeopardize the employee’s retirement benefits, and both are subject to complex rules that, if not carefully observed, can put both the employee and the plan itself at risk.
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Going over some rules
In today’s uncertain economic climate, many employees are experiencing financial hardships, maybe because of a mortgage that has become unaffordable, burdensome credit card debt, or even a job loss in the family. While most employees understand the importance of planning and saving for retirement, some may need immediate access to their retirement funds to prevent financial disaster. Many, but not all, retirement plans (and in particular, defined-contribution programs like 401(k) plans) permit employees to borrow or withdraw funds permanently from their accounts. Since employers can expect inquiries about loans and withdrawals to mushroom in difficult economic times, here’s a quick refresher on the rules in this area.
First, not all plans can offer loans and withdrawals, and no plan is required to offer them.Traditional defined benefit pension plans typically don’t offer loans. Defined benefit and defined contribution (money purchase) pension plans generally don’t permit in-service withdrawals (regardless of hardship) prior to normal retirement age (normally 65). However, a recent law change allows such withdrawals at or after age 62, if the plan document so permits. And although any defined contribution plan (money purchase pension, profit-sharing, or 401(k)) may offer loans, many don’t, either for philosophical reasons or because they don’t want to incur the administrative costs and complexities involved.
Many defined-contribution plans — and 401(k) plans in particular — do permit in-service withdrawals, generally on a hardship basis, and hardship withdrawals are a major focus of this article. Loans are not permitted from individual retirement accounts (IRAs) or employer plans based on IRAs, such as simplified employee pension plans (SEP plans) and Savings Incentive Match Plan for Employees IRAs (SIMPLE IRAs). Such plans generally do permit withdrawals (with or without hardship), but the tax consequences can be severe, as noted below.
Plan loans and withdrawals have fundamentally different financial and tax consequences. As their names suggest, a loan must ordinarily be repaid, while a withdrawal is permanent and normally may not be returned to the plan. If a plan loan is repaid on schedule, the funds are returned to the employee’s plan account and thus can continue to fund his retirement. On the other hand, withdrawn funds become permanently unavailable for that purpose, at least within the confines of the plan itself.
Looking at the loan, withdrawal process
If a plan permits loans, the employee completes an application and submits it to the plan administrator. Loans must generally be repaid within five years, with the exception being loans used to acquire a principal residence, which may carry longer terms. Loans must also bear a reasonable rate of interest and be amortized (repaid) through level payments on at least a quarterly basis over the term of the loan (no balloon payments). Plans generally require that active employees’ loan repayments be made through payroll deductions.
The maximum loan amount is generally limited to 50 percent of the employee’s vested account balance, with a maximum loan balance of $50,000. The tax regulations applying these limits discourage the employee from maintaining a continuous loan account balance by, for example, repeatedly rolling over outstanding loans at the close of each five-year repayment period. Plans often impose a minimum loan amount (typically $1,000), provide that an employee may have no more than one loan outstanding at any time, and charge an application or processing fee, which may be deducted from the employee’s account or the loan proceeds. Finally, if the employee is married, the spouse’s written, notarized consent is usually required to obtain the loan.
The process of securing a withdrawal (and 401(k) plan hardship withdrawals in particular) is somewhat more onerous. The plan document will generally specify whether and under what circumstances withdrawals are permitted. Withdrawals are generally intended to address unforeseeable expenses faced by employees or their spouses, dependents and, in certain cases and if the plan so permits, primary plan beneficiaries of employees (including, for example, domestic partners currently not treated as spouses or dependents under federal law), where the expense cannot be met by using other available resources (including plan loans, if available). Many plans permit hardship withdrawals only to defray expenses incurred in connection with one or more of the following “safe harbors” prescribed by IRS regulations:
- unreimbursed medical expenses of the employee or certain other authorized persons;
- anticipated post-secondary educational expenses of the employee or certain other authorized persons for the next 12 months;
- funeral expenses for certain authorized persons;
- purchase of the employee’s principal residence;
- repairs to the employee’s principal residence after a casualty loss; or
- prevention of eviction or mortgage foreclosure involving the employee’s principal residence.
If the plan limits the grounds for hardship withdrawals to some or all of those six circumstances, the employer may not permit withdrawals for any other reason, no matter how real and urgent the hardship may be from the employee’s perspective. For example, even undergoing a divorce, having burdensome credit card debt or auto repair expenses, and facing extraordinary winter heating fuel costs don’t constitute grounds for a hardship withdrawal under the IRS safe-harbor regulations. Some plans don’t limit hardship withdrawals to the safe harbors; in that case, participating employees may be accorded more flexibility. On the other hand, the withdrawal application and review process may be more prolonged and rigorous.
Employees are generally required to provide proof of the claimed hardship in their applications. Many plans also prohibit employees taking withdrawals from contributing to the plan for six months. Some plans permit hardship withdrawals only from the employee’s elective deferral account in the 401(k) plan, not from employer-matching or profit-sharing contributions. As noted before, while IRA-based plans don’t permit loans, they normally permit withdrawals, with no proof of hardship required. However, those withdrawals are still taxable to the employee (including, in most cases, penalty taxes for employees younger than 59-1/2).
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Plan loans and withdrawals can provide a useful safety net for financially pressed employees under certain circumstances. However, these strategies should be viewed as a last resort because they can put the employee’s retirement funds in jeopardy. Hardship withdrawals in particular carry severe tax consequences, which can simply add to the employee’s financial woes at a time of maximum vulnerability. Finally, even if a loan or withdrawal seems appropriate, the plan administrator and employee must follow the applicable regulations to the letter to avoid serious potential consequences for the employee and the plan itself.
Douglas R. Chamberlain is a senior member of Sulloway & Hollis, P.L.L.C. His practice includes advising businesses and professional groups, particularly in the health care field. He also practices extensively in the area of employee benefits, assisting clients with their 401(k) and other retirement plans as well as fringe benefit programs of all types. He can be reached at (603) 224-2341.