Correction of improper Hardship Distribution

[Guest M. Martin]

What are the proper channels of correction if a participant refuses to repay an improper hardship distribution?

The auditor preparing the financials for the 2007 Form 5500 discovered a participant had requested and received a hardship distribution but did not disclose it was for expenses paid in 2006. The participant did certified that the hardship was for post-secondary educational expenses but not for when they were paid.

The proposed solution is to send a letter to the individual requesting the return of the funds plus any applicable earnings. The plan administrator does not think the participant is in a position to restore the funds. The participant is under age 59½ and does not qualify for an in-service distribution or have sufficient funds for a loan.

From a taxability stand point for the participant a corrected 1099-R will need to be issued and the early withdrawal penalty will apply. However, in the event the funds cannot be restored what are the consequences to the plan?

[Guest Sieve]

I assume you are using the safe harbor hardship distribution rules and that this is a 401(k) plan.

First off, it doesn't sound like there are very good plan procedures in place to determine if a hardship actually is a hardship--there should have been a copy of the bill provided before a hardship distribution was authorized. Secondly, why is a corrected 1099 going to be issued? It should already have been issued for the year in which the distribution was made, and the early withdrawal penalty also would have applied when the distribution was made (because the particiant was not 59-1/2)--there is no exception from the excise tax or the issuance of a 1099 for a hardship distribution (although some IRA distributions for education expenses are exempt from the excise tax). Third, you can correct under EPCRS as an operational failure, but you must develop administrative procedures to explain in the application why this same event will not happen again. Fourth, don't expect to get the $$ back from the participant--even if they have the ability to repay.