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IRS takes it easy on hardship withdrawals

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In a perfect world, employees wouldn’t tap their 401(k) or other tax-qualified retirement plan until retirement. But a client might be forced to take drastic measures when facing a personal emergency.

Strategy: Have the client apply for a “hardship withdrawal” when the plan permits it. If the client qualifies, he or she can take out money from the plan for personal reasons.

The Pension Protection Act of 2006 authorized the IRS to revise the existing regulations for hardship withdrawals. Now the agency has issued new guidance opening the door to more plan participants. (IRS Notice 2007-7)

Background: An employee can take a hardship withdrawal from a 401(k) plan up to the amount of elective deferrals upon severance from employment, plan termination, death, disability or a hardship. The IRS defines a hardship withdrawal as one being made because of an “immediate and heavy financial need.” Also, the withdrawal cannot exceed the amount necessary to satisfy that need.

Qualified hardship withdrawals may include amounts used to pay for the following:

  • Medical expenses of an employee, spouse or dependent.
  • College tuition of an employee, his or her spouse or a dependent.
  • Expenses to purchase a principal residence for an employee (excluding mortgage payments).
  • Expenses to stave off eviction or foreclosure of the employee’s principal residence.
  • Burial or funeral expenses for an employee’s deceased parent, spouse, child or dependent.
  • Expenses for repairing casualty damage to an employee’s principal residence.

Similar rules apply to other tax-qualified plans permitting elective deferrals.

New rules: Under Notice 2007-7, the IRS expands the rules for hardship withdrawals to individuals qualifying as a “primary beneficiary” under the plan. A primary beneficiary is someone who:

  1. Is named as a beneficiary of the plan.
  2. Has an unconditional right to all or part of the plan participant’s account balance upon the participant’s death.

Even if the plan adopts this provision, the employee still must meet the other requirements (e.g., the need for an immediate and heavy financial need).

Note: This gives plan participants greater flexibility. A primary beneficiary could be a relative who is not a spouse, child or dependent, or even a non-relative.

The new Notice applies to distributions made after Aug. 16, 2006.

Of course, hardship withdrawals are still subject to income tax in the year they are paid out. Also, an individual may be liable for a 10 percent penalty for early withdrawals, unless a special exception applies.

Tip: Alternatively, an employee might borrow money from his or her 401(k) and repay it over time with interest.

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