When may an employee take a hardship distribution from his 401(k) plan?

Hardship withdrawals from a Code Section 401(k) plan, limited to the amount of an employee's elective deferral, are permitted if:

1. the participant has an immediate and heavy financial need, and

2. the distribution is necessary to satisfy the participant's financial need.

The determination of immediate and heavy financial need and of the amount necessary to meet the need must be made in accordance with nondiscriminatory and objective standards stipulated in the plan.

Distribution cannot exceed need. A distribution will not be treated as necessary to satisfy an immediate and heavy financial need to the extent that it exceeds the amount required to relieve the need or to the degree the need may be satisfied from other resources reasonably available to the employee. An employee's resources include assets of the employee's spouse and minor children that are reasonably available to the employee. The amount distributed for immediate and heavy financial need may include funds necessary to pay any federal, state or local income tax and penalties resulting from the distribution.

A distribution generally may be treated as necessary to satisfy a financial need if the employer reasonably relies upon the employee's representation that the need cannot be relieved:

• through reimbursement or compensation by insurance or otherwise;

• by reasonable liquidation of the employee's assets (to the extent that such liquidation would not itself cause an immediate and heavy financial need);

• by other distributions or nontaxable (at the time of the loan) loans from the plans of the employer or by borrowing from commercial sources at reasonable terms; or

• by cessation of elective contributions or employee contributions under the plan.

Hardship distribution limited to amount of elective contributions. The amount available for hardship withdrawal is generally limited to the employee's total elective contributions as of the date of the distribution, reduced by the amount of any prior hardship distribution.

Final regulations. Regulations finalized by the IRS in December 2004 require a representation by an employee that a distribution is necessary to satisfy an immediate and heavy financial need (including funeral expenses and the cost of repairs to a principal residence) to establish that the need cannot reasonably be relieved by any available distribution or nontaxable plan loan (even if the distribution or loan would not be sufficient to satisfy the financial need). However, an employee would not be required to take a commercial loan if a loan sufficient to meet the employee's needs would not be available on reasonable commercial terms. In addition, the final rules clarify the 6-month suspension of elective deferrals following a distribution rule implemented by the Economic Growth and Tax Relief Reconciliation Act of 2001.

Dependent expenses. The Working Families Tax Relief Act of 2004, effective beginning in 2005, modified the definition of a dependent under Code Sec. 152. The final 401(k) rules effectively allow medical expenses and post-secondary education expenses for an employee, spouse, or dependent (without regard to the modified definition of dependents) to be treated as a deemed heavy and financial need.

401(k) hardship withdrawal changes pursuant to Pension Protection Act of 2006. The new law instructs the Treasury to issue rules within 180 days of enactment (the law was signed by President Bush on August 17, 2006) that allow 401(k) plan withdrawals for hardships and unforeseen financial emergencies with respect to any person who is listed as a beneficiary under the 401(k) plan. The Treasury rules are to be consistent with hardship withdrawals now allowed for spouses and Code Sec. 152 dependents.