Failure to Suspend Contributions following Hardship Withdrawal

[Guest rocnrols2]

Assume that a 401(k) plan permits hardship withdrawals using the safe harbor method. An internal audit discovers that the plan has failed to suspend contributions on numerous occasions. What is the appropriate method of correcting this error under EPCRS?

[Tom Poje]

This is a little old, but it is probably still applicable: (It is from the Q & A board on this website)

Correcting Plan Defects Q&A

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by Attorneys C. Frederick Reish, Bruce L. Ashton, Nicholas J. White and Nicholas J. Waddles of Reish Luftman McDaniel & Reicher, a Professional Corporation. Mr. Reish and Mr. Ashton are the co-authors of the Plan Correction Answer Book (click for details), from Panel Publishers.

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Failure to Follow the Plan's Terms Regarding Hardship Distributions

(Posted August 16, 1999)

Question 110: A reader asks the following question: "In the first year of a 401(k) plan, an employer allowed two participants to receive hardship distributions without completing any required paperwork. The employer also allowed the participants to continue to make deferral contributions to the plan. Can this situation be corrected? What would be the method of correction?"

Answer: In answering this question, we have made the following assumptions: (1) the plan document permits hardship distributions; (2) the distributions were made on account of bona fide hardships; (3) the terms of the plan require that hardship requests be made in writing; and (4) the plan's terms provide for suspension of elective deferrals for at least twelve (12) months after the distribution.

The failure to comply with the required hardship "paperwork" and suspension of deferrals is a failure to operate the plan in accordance with its written terms, and as such, is an operational failure as described in Section 5.01(2) of Rev. Proc. 98-22. If the IRS were to audit the plan and discover this error, it could seek to disqualify the plan on the basis that the failures violate the definite written program requirements of Code section 401(a) and Regulations section 1.401-1(a).

The correction is to (1) complete the relevant paperwork, dated currently but with a retroactive effective date to the date of the hardship distribution (this would include obtaining any applicable spousal consents in accordance with Code sections 401(a)(11) and 417), and (2) return to the participants the deferrals they made during the 12-month period following the hardship distributions, plus any related earnings. It has been our experience that this method of correction is acceptable to the IRS, because it meets the requirements in Section 6.02(1) of Rev. Proc. 98-22 that "[t]he correction method should restore the plan to the position it would have been in had the Qualification Failure not occurred. . . ." As an operational failure, correction prior to an IRS audit can be made under either APRSC or the VCR Program.

Under Parts IV and V of Rev. Proc. 98-22, operational failures can be voluntarily corrected without IRS involvement under APRSC, or with IRS involvement under VCR. Assuming the plan meets the eligibility requirements of APRSC (see Q&A #90 for a discussion of those requirements) and that the correction can be substantially completed prior to the end of the second plan year following the plan year in which the defects occurred, then the failures should be corrected under APRSC to save the time and avoid the filing fee required to resolve the failures under the VCR Program. If the failures are corrected outside the two-year time period, then APRSC can be used only if the failure is "insignificant" under all the facts and circumstances of the case. If the failure is "insignificant," it can be corrected under APRSC even if the plan comes under audit prior to the time correction is made.

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Important notice: Answers are provided as general guidance on the subjects covered in the question and are not provided as legal advice to the questioner's situation. Any legal issues should be reviewed by your legal counsel to apply the law to the particular facts of your situation. The laws, regulations and court decisions in this area change frequently. Answers are believed to be correct as of the posting dates shown. The completeness or accuracy of a particular answer may be affected by changes in the laws, regulations or court decisions that occur after the date on which that Q&A is posted.

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