The ERISA consultants at the Learning Center Resource Desk, which is available through Columbia Threadneedle Investments, regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with an advisor in North Carolina is representative of a common inquiry regarding hardship distributions from 401(k) plans. The advisor asked:
“What is the proper means of correction if a 401(k) plan participant receives a hardship distribution and the plan sponsor subsequently fails to suspend employee salary deferrals for the individual for six months as required by the plan?”
- This is an excellent question to which there is no definitive answer. The IRS has indicated failing to suspend employee salary deferrals for the plan-specified period of time after receiving a hardship distribution is a “very common problem.” Yet, while the IRS’ correction programs in the Employee Plans Compliance Resolution System (EPRCS) address numerous plan errors, they do not specifically address this type of failure.
- The IRS has provided informal guidance on the matter in one of its many phone forums, "Grab the Money and Run? Retirement Plan Loans and Hardship Distributions." The IRS’ general principle is to put the participant in the same position he/she would have been in had the failure not occurred. Consequently, the most prudent approach is to treat the error as an excess deferral under the plan.
- To correct it, the plan sponsor would need to distribute the excess deferrals, adjusted for earnings. Depending on the relative significance of the mistake and how much time has passed since its discovery, the plan sponsor may be able to correct the error on its own, without IRS approval (i.e., Self Correction Program, or SCP); or the plan sponsor may need to make a Voluntary Correction Program (VCP) submission. In order to fix the mistake under SCP, generally the mistake must be corrected within two years after the end of the plan year is which the failure occurred. Unless the failure can be classified as insignificant, VCP must be used after this time.
Conclusion
Failing to temporarily suspend employee salary deferrals after a participant receives a hardship distribution from his or her 401(k) plan is a common error. While no formal corrective measures have been issued, the IRS has informally indicated the deferrals during the suspension period should be treated as excess deferrals and corrected as such.
The Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC (RLC), a third-party industry consultant that is not affiliated with Columbia Threadneedle. Any information provided is for informational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Threadneedle does not provide tax or legal advice. Consumers consult with their tax advisor or attorney regarding their specific situation.
Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Columbia Threadneedle.
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