Withholding on hardship distributions

[Jim Chad]

My understanding is that hardship Distributions from deferrals are not eligible for rollover and are subject to voluntary withholding. What do you all think of an administrative policy (not in 401(k) documents) that mandates 20% withholding because it is " so much easier to explain and process". There have been some long conversations with an employee about how much should she have withheld. What do you all think?

[ETA Consulting LLC]

I agree with you on the rules, but would not subscribe to an administrative policy that would contradict language written in the special tax notice. Section 3405 of the IRC outlines the rules; and they aren't exactly abitrary.

To your specific case, however, the amount of hardship requested may be increased by the expected taxes to be paid. So, the person may request an additional 30% for the taxes; and also request 30% withholding (like you said, discretionary); but an administrative policy making a certain amount mandatory is a little too aggressive.

I would, respectfully, yield to a KevinC or Sieve on this one; not to call anyone out, but they've corrected my thinking on several occassions (which has truly earned my respect).

[K2retire]

The withholding rules are one of the best examples of how our tax regulations do not make sense!

We have mandatory 20% withholding on many types of distributions, although we do not have a 20% tax bracket. For people under age 59 1/2 who will owe the 10% tax penalty, have you ever heard of anyone getting a plan distribution whose marginal tax rate was only 10%? So we annoy people by withholding in the first place, then for most of them, we don't withhold nearly enough to cover the actual tax bill so they owe even more when they file their tax returns.

But we make an exception and don't require withholding from hardship distributions. The people who have money management skills such that they need a hardship distribution are more likely to figure out the tax consequences of that distribution than the general public. Right?

Off my soap box for now....

[JanetM]

K2, you got that right. The folks who take hardships don't always have the $$ skill to figure it out. I will caveat that - not all those who take hardships have lack of money skills, most were just dealt a bad deal.

[ESOP Guy]

Why aren't hardship distribution subject to 10% withholding per IRC §3405(b)(1)?

The way I read it they can elect out of that withholding, but the default is withhold the 10% unless the person makes an election.

Maybe that is what people mean by voluntary witholding. But to me it is slightly different. You do have to give them the W-4p and they have to elect out. And more and more I just see people not withholding without the W-4P saying they elect out.

Maybe it is my just my experiance. At this job I am working on my 401(k)s than my old job, which was almost all ESOPs and balance forward PS plans that had odd allocation formulas.

Although I was on a recent John Hancock webinar where the person just said you never have to withhold on hardships and when I asked about the 10% they never bothered answer the question.

I am asking more for my benefit than challenge anyone else here. I am rustly enough I am just double checking my thought process.

[Peter Gulia]

A wild, and perhaps crazy, idea: Imagine a hardship claim form that allows the claimant to specify a percentage for each Federal, State, or other income tax withholding that the claimant requests. The form also says that the "gross-up" (from the demonstrated need amount to the distribution amount the plan pays) is computed from the sum of those tax-withholding percentages (or, if less, from the sum of the highest marginal rates of the taxing jurisdictions that the claimant requests withholding for). While it might be a moment more in work that can be computerized, tieing the gross-up to withholding would illustrate the relationships in a way that might assuage some of the concerns that Jim Chad describes.

Any takers for criticism of this idea?

[Jim Chad]

Peter, I like your idea. What does everyone think? Would this be a legal replacement for the form W-4P?

Also, we are back to HR concerns about giving people these choices. People don't know what to do and waste a lot of time asking HR people questions to help them make the decision. They are smart enough to refuse to give tax advise, but still a lot of their time is wasted.

[austin3515]

The withholding rules on distributions are insane... I can't believe that you can't elect to have MORE than 20% withheld if you want to without filling out some other tax form....

Fiduciary, some forms from some providers already do allow that. My experience is that most people skip on the withholding. They want as much money as possible...

[Peter Gulia]

The procedure that I invite criticism on is based on the idea that a "gross-up" in a hardship distribution is permissive, not mandatory. (I regret not writing a full explanation while my wife was waiting for me to leave the office for Friday supper.)

Under this idea, a plan would provide (whether expressly in the plan's documents or at least by implication of the plan's written procedures) that a "gross-up" cannot be more than what the claimant requests to be withheld for income taxes. Thus, a claimant who wants to get the most money that the plan allows would be motivated to request more withholding. By requesting at least "enough" withholding (to meet anticipated income taxes), a claimant's net distribution (after withholding) would be the amount of the demonstrated need.

Admittedly, the regime now used by many plans - providing a "gross-up" that assumes some middle or high marginal income tax rates and an additional 10%, but allowing a claimant to choose much less withholding - pays more immediate money for the participant to spend. But it does so by allowing a person to "borrow" by not setting aside enough money to meet his or her tax obligations. That this might be against a participant's better interests seems to be a concern that an employer could choose to help a participant plan against.

Some of this gets to a "philosophical" discussion about how involved (or not) an employer should be in helping its employees manage the personal weaknesses of some of them. Moreover, different employers with different people can have different ideas about this.

But can a procedure that ties "gross-up" to withholding be useful for those employers that do want to guide their employees?

And is there any advantage if a form could show in big and bold letters:

The hardship amount you say you need: $10,000.00

The tax-withholding percentages you request: Federal 28% + 10% State 5% Local 2%

The amount you would take out of your Plan Account if we approve your claim (and tax-withhold as you request): $18,181.82

The amounts you request the Plan to withhold toward your income taxes: Federal (38%) $6,909.09 State (5%) $909.09 Local (2%) $363.64

The check the Plan would pay you (if we approve the hardship amount you claim): $10,000.00

[K2retire]

I love the concept. The graphic explanation of how much this withdrawal is really going to cost is fabulous. But in my experience most employers and virtually all record keepers are so concerned about possible liability for giving tax or legal advice that I doubt they will embrace this idea.

[ESOP Guy]

The procedure that I invite criticism on is based on the idea that a "gross-up" in a hardship distribution is permissive, not mandatory. (I regret not writing a full explanation while my wife was waiting for me to leave the office for Friday supper.)

Under this idea, a plan would provide (whether expressly in the plan's documents or at least by implication of the plan's written procedures) that a "gross-up" cannot be more than what the claimant requests to be withheld for income taxes. Thus, a claimant who wants to get the most money that the plan allows would be motivated to request more withholding. By requesting at least "enough" withholding (to meet anticipated income taxes), a claimant's net distribution (after withholding) would be the amount of the demonstrated need.

Admittedly, the regime now used by many plans - providing a "gross-up" that assumes some middle or high marginal income tax rates and an additional 10%, but allowing a claimant to choose much less withholding - pays more immediate money for the participant to spend. But it does so by allowing a person to "borrow" by not setting aside enough money to meet his or her tax obligations. That this might be against a participant's better interests seems to be a concern that an employer could choose to help a participant plan against.

Some of this gets to a "philosophical" discussion about how involved (or not) an employer should be in helping its employees manage the personal weaknesses of some of them. Moreover, different employers with different people can have different ideas about this.

But can a procedure that ties "gross-up" to withholding be useful for those employers that do want to guide their employees?

And is there any advantage if a form could show in big and bold letters:

The hardship amount you say you need: $10,000.00

The tax-withholding percentages you request: Federal 28% + 10% State 5% Local 2%

The amount you would take out of your Plan Account if we approve your claim (and tax-withhold as you request): $18,181.82

The amounts you request the Plan to withhold toward your income taxes: Federal (38%) $6,909.09 State (5%) $909.09 Local (2%) $363.64

The check the Plan would pay you (if we approve the hardship amount you claim): $10,000.00

Peter, am I understanding what you are saying correctly is this: You don't gross just the 10% or 20% withholding but gross up based on a good faith estimate made by the requester of what his actual taxes will be when he files his tax return? Because if you are saying that I once worked with a large employer that allowed its people to do just that. and so we were grossing the hardship up by 30-40% at times if the person had a fairly high income and lived in high income tax state/city.

To me the difficulty was how much should the employer try and check the estimate? If a person claimed his final tax bill was going to be 60-70% should that be rejected? If so, on what grounds you don't actually know this person's tax situation.

By the way no one answer my earlier question. Do I have some basic misunderstanding of this issue?

[BG5150]

I have kind of an ancillary question to this thread:

If someone is supposed to complete a W4-P in order do opt out of taxes, or to add to the taxes taken, is it a viable replacement to pose the question on the distribution form itself? I've seen numerous carriers give the option of "0%, 10% or other" in a section of the request form.

Is that ok?

[masteff]

I like Peter's suggestion and would love to see the regs say that grossup shall be based on reasonable marginal tax rates and can't exceed amount of withholding.

To me the difficulty was how much should the employer try and check the estimate? If a person claimed his final tax bill was going to be 60-70% should that be rejected? If so, on what grounds you don't actually know this person's tax situation.

By the way no one answer my earlier question. Do I have some basic misunderstanding of this issue?

1) I agree w/ your earlier statement. 3405(b)(2) seems to require an election; and unless there's some guidance I'm not aware of, I don't know how the employer can legally make an election of less than 10% on the ee's behalf.

2) When I administered hardships at previous job, it was very easy to go to each state's tax authority and see their rate structure. So it's pretty easy to do a "smell test" on the tax rates being used for the gross up. As plan administrator, I actually dictated what was reasonable (and consistent w/ prior practice) for grossup based on known payroll information (I strictly generalized, never tried to work backwards into the EE's actual situation); if someone claimed to be in a significantly higher tax bracket then I wasn't bashful about requesting supplemental documentation (e.g., page 2 of prior year's tax return which shows taxable income, spouse's W-2, etc).

If someone is supposed to complete a W4-P in order do opt out of taxes, or to add to the taxes taken, is it a viable replacement to pose the question on the distribution form itself? I've seen numerous carriers give the option of "0%, 10% or other" in a section of the request form.

Is that ok?

I didn't read all of Reg 35.3405-1T, but looking at, for example Q&A d-23, I'm going with: yes, it's ok. (Also, the regs covering the W-4 in 31.3402(f)(5)-1 allow the use of an alternative form if the proper instructions, etc are included; I see no reason that doesn't extend to the W-4P.)

[Peter Gulia]

The idea allows a participant to request voluntary withholding, and then computes the "gross-up" on no more than that ACTUAL withholding.

[The hardship claim form builds in a substitute for Form W-4P. There is a regulation that governs how to do such a substitute.]

As in my first post on this, I do suggest limiting the gross-up based on the sum of the highest marginal rates of the taxing jurisdictions that the claimant requests withholding for - or some other rule of reason that approximates that effect. For example, if the claim states that the participant resides only in a place that has no State or local tax, the maximum gross-up should be restrained based on no more than 45% [35% + 10%] withholding toward Federal income tax.

A plan sponsor or plan administrator should limit the gross-up based on the highest marginal tax rates that could apply to a participant (for example, about 57.846% for a resident of the State and City of New York [and more for years after 2012]). To simplify this point, a sponsor or administrator might restrain a hardship distribution to no more than double the demonstrated-need amount (thus allowing no more than 50% for income taxes).

An employer does not know its employee's (and his or her spouse's) income beyond the wage that the employer pays. So it might be reasonable to provide a gross-up that is grounded on an actual withholding election that specifies a percentage up to the highest marginal rate that could apply. (For example, if a claim states that the participant resides only in Philadelphia, a plan might allow Federal 45%, Pennsylvania 3%, Philadelphia 4% [52%].) Again, because a "gross-up" gets quite steep for any marginal tax rate above 50%, a sponsor or administrator might stick with a no-more-than-double rule, perhaps reasoning that perfect even-handedness is not required concerning those who have the highest incomes.

Tieing the hardship gross-up to actual withholding restrains a participant who otherwise might be motivated to suggest that his or her "reasonably anticipated" income taxes are more than they really are. Because a claim gets a gross-up based on the withholding requested, the net distribution never is more than the demonstrated-need amount.

And for a lower-income distributee, the idea helps a claimant see that 10% withholding toward Federal income taxes usually is not enough.

I suggest showing the percentage that a claimant ought to request for Federal income taxes as the sum of two percentages: nn% plus 10%, with an explanation that a participant should want withholding of the extra 10% unless that early-distribution tax does not apply.