Brenda Wren

Hardship withdrawal - grossed up for taxes

14 posts in this topic

I understand that (1) hardships can be used to purchase a primary residence, (2) hardship withdrawal amounts can be grossed up for taxes and penalties and (3) withholding is optional.

I have a hardship withdrawal on my desk with a Good Faith Estimate indicating that the ee needs to bring $5,480 to home purchase closing. The participant is requesting $8,000 with no withholding. The client is looking to me to bless the amount needed to satisfy the "immediate financial burden". Since no one really knows the tax liability, i.e. tax rate, until the end of the year (except the rich folks, of course) is there any guidance from IRS on the appropriate tax rate to assume when grossing up the hardship distribution for taxes and penalties? I am inclined to recommend 15% plus 10% which would put the actual hardship distribution amount at $7306.67, but I really have no basis for that thinking.

Also, not that I want to make up rules, but it doesn't seem logical that an employee can elect to have the distribution grossed up for taxes and penalties, then turn around and also elect no withholding. Of course, logic is not law or guidance for that matter!

Sal's book says "reasonable".

What would you do?

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Our form for our clients includes this: "Your request may include an additional amount to cover anticipated tax liability associated with this withdrawal. Your employer may require evidence to support this additional amount. "

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Does this person make more than (about) $28,000? He may have other income you are not aware of. Then you should use the 25% level. Plus, did you take into account possible state taxes?

Also, I see nothing wrong with grossing up for taxes and then taking the whole thing. The money will ahve to be paid sometime.

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Thanks, Brian. Living in Florida, I never think about state taxes. This guy lives in Arizona; I have no idea if they have a state income tax or not.

He makes around $50K. But I have no clue about other income or deductions.

Are you saying that you would gross up the amount....25% for taxes plus 10% for the penalty to arrive at $8430 and therefore process the hardship at the original $8,000 he requested?

I normally wouldn't belabor such a silly thing as this, but I've been dealing with IRS and DOL auditors lately and it seems my clients are having to justify at great length every tiny thing they do upon audit.

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I went to this site to do a rudimentary tax braket analysis:

Fairmark

That's where I got the 25%. So the calculation $5480 / .65 = $8430.

It all depends on the tax bracket. If the participant and the plan administrator believes this is a "reasonable" approximation of the taxes, you're okay.

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I agree with Brian.

Instead of guessing, could the participant have insight on what their marginal rate will be (as long as it sounds reasonable, I'd use it)?

Arizona state taxes run from about 3% to 5% marginal rates. (Also note that some states follow the feds with their 10% early distribution tax; for example Wis uses, or once used, an extra 3%. I don't know what Arizona does.)

In response to your question about the oddity of no withholding, I see absolutely nothing problematic about that. You don't know what the person's existing withholding looks like -- it could be based on not having home deductions and they may not want to be overwithheld once they have the larger deductions in place. Withholding and tax liability are two very separate issues. As long as the person has the right to not withhold, their invoking that right shouldn't have any bearing on what you do.

Edited by MGB

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Thanks for the input guys. I think I am overly concerned envisioning the DOL hammering the client about violating the rule "cannot exceed the amount required to meet the immediate financial burden".

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I have never interpreted the "gross up for taxes" as being for the long run. I always thought this rule dealt more with the fact that you used to have to withhold 20% from hardships. However, I can see how you could it interpret it that way. Just wanted to bring that up for discussion. Any comments?

Edited by Archimage

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I always thought this rule dealt more with the fact that you used to have to withhold 20% from hardships and you still do if you are taking a hardship from a source other than deferrals

You do not have to withhold 20% from any source of money being taken for hardship withdrawal since none of it is eligible for rollover.

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You are right. I have no idea why I wrote that part. :blink:

I edited my post accordingly.

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Had the participant simply come in requesting $8,000 for the home closing, would you have granted it?

My point is how do you know whether other requests have included a gross up or not? Do you require substantiation of the amount if there's no mention of a gross up? Or did you just stumble across the fact the amount was grossed up?

Finally, what's the harm in asking the participant to simply provide a written statement that the difference represents his calculation of his estimated federal, state and local taxes plus the federal 10% early withdrawal penalty and any other state penalty?

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Hardship withdrawals from 403(b) arrangements may not include earnings just contributions. Is it the same with 401(k)?

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The gross up for taxes was there even when there was the mandatory withholding. Participants would often gross up 35-40% to allow for their tax bracket, state taxes and the penalty.

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Gregory--the very first post said that the estiimate was for $5480. There's no guessing on the immediate need, just the "gross up".

Joel--in 401(k) plans: for 401k deferrals, only contributions may be taken. If the plan allows for other sources (such as match or profit sharing) contributions and earnings may be taken. It's all up to the plan document.

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