Loan not taken before Hardship Withdrawal

[pixmax]

We have a client who let a participant take a hardship withdrawal without requiring them to take a loan. The client states that they weren't aware that they had a loan program. They have also not stopped 401k deductions. We have instructed them to stop the deductions now. I assume that this is an operational failure and it should be self corrected. Is this a prohibited transaction? Would we file a 5330 with a 15% penalty on the amount that was distributed in error or does nothing need to be done?

[Tom Poje]

arguably someone who is in need of a hardship is a bad credit risk, and therefore could be denied a loan, and I'll stress the word 'could', proving it may be another thing, but still if someone needs a hardship because they can't pay bills, how can you expect them to pay the loan?

going way back, at the 1999 ASPPA Conference

#46. A participant took a 401k hardship distribution pursuant to the hardship safe harbor rules, but was allowed to continue making 401k deferral contributions in violation of the 12-month suspension rule. What are the possible methods of correcting this error under APRSC?

1.Start a full 12-month suspension when the error is discovered?

2.Distribute impermissible deferrals and earnings?

3. Return deferrals and suspend for balance of original 12-month period?

IRS response; Starting a new 12-month period doesn't meet the rules. Deferrals (and match, if applicable) should be forfeited and the balance of the 12-month suspension should be applied. Of course, the employee should be made whole outside of the plan (i.e., no distribution from the plan to the employee).

............

from an old benefits link thread

We have submitted a VCP to the IRS on this very issue. Initially, we proposed to take out the contributions that should not have been made plus earnings and this was approved. In attempting to implement this, however, we found that most of the affected participants did not have sufficient amounts in the money types in question (because of subsequent loans and/or withdrawals) to make this an unworkable solution. We went back to the IRS and they proposed a prospective suspension. The problem was that a number of years had elapsed between the time the amounts were improperly contributed, the first compliance statement was issued and then the second VCP request was submitted and resolved and a final compliance statement issued, that the participants who were impacted complained that the prospective suspension would be coming when they earned a much higher rate of pay. The bottom line is, if you are consider the refund method, take a look to see if there would be sufficient money in the participants' accounts to effect the refund. If not, then use the prospective suspension.

8/10/2007 Benefits Link posting (Note: I wouldn’t try it other than under VCP)

[pixmax]

arguably someone who is in need of a hardship is a bad credit risk, and therefore could be denied a loan, and I'll stress the word 'could', proving it may be another thing, but still if someone needs a hardship because they can't pay bills, how can you expect them to pay the loan?

going way back, at the 1999 ASPPA Conference

#46. A participant took a 401k hardship distribution pursuant to the hardship safe harbor rules, but was allowed to continue making 401k deferral contributions in violation of the 12-month suspension rule. What are the possible methods of correcting this error under APRSC?

1.Start a full 12-month suspension when the error is discovered?

2.Distribute impermissible deferrals and earnings?

3. Return deferrals and suspend for balance of original 12-month period?

IRS response; Starting a new 12-month period doesn't meet the rules. Deferrals (and match, if applicable) should be forfeited and the balance of the 12-month suspension should be applied. Of course, the employee should be made whole outside of the plan (i.e., no distribution from the plan to the employee).

............

from an old benefits link thread

We have submitted a VCP to the IRS on this very issue. Initially, we proposed to take out the contributions that should not have been made plus earnings and this was approved. In attempting to implement this, however, we found that most of the affected participants did not have sufficient amounts in the money types in question (because of subsequent loans and/or withdrawals) to make this an unworkable solution. We went back to the IRS and they proposed a prospective suspension. The problem was that a number of years had elapsed between the time the amounts were improperly contributed, the first compliance statement was issued and then the second VCP request was submitted and resolved and a final compliance statement issued, that the participants who were impacted complained that the prospective suspension would be coming when they earned a much higher rate of pay. The bottom line is, if you are consider the refund method, take a look to see if there would be sufficient money in the participants' accounts to effect the refund. If not, then use the prospective suspension.

8/10/2007 Benefits Link posting (Note: I wouldn’t try it other than under VCP)

[pixmax]

Hey Tom, I understand the hardship criteria. They have no back up of why he needed the hardship, they just approved and went on. So it sounds like I need to file under VCP. Do they have to file under VCP or can they just do a Self correction and pay an excise penalty on the deferrals that should have been stopped? Should they stop deferrals now or should we just calculate the 6 months that was withheld with interest? I assume this gets distributed back to the participant and taxed. It only affects one participant in a 403b plan and I would hate to have to go through VCP if they didn't really need to.

Thanks for your help on this.

[Tom Poje]

might look at

If impermissible hardship distribution, have participant return hardship distribution amount plus earnings

Potential mistake #10, 401-K Fix It Guide

http://www.irs.gov/pub/irs-tege/401k_mistakes.pdf#page=2

nothing there that the IRS speaks of VCP that I recall

amazing some of the things I have at my finger tips, huh? (got stuck trying to throw some notes together for a talk on different issues involving distributions, so I included this, about all I can find on the topic)

...........

by the way, the IRS put out some nice guidelines on hardships last year

http://www.irs.gov/pub/irs-tege/rne_sum09.pdf