03.24.2020 | COVID-19

In-Service Distributions, Hardship Distributions, and Loans from Retirement Plans

By Scott E. Galbreath

COVID-19 Client Alerts:

In-Service Distributions, Hardship Distributions, and Loans from Retirement Plans

In-Service Distributions, Hardship Distributions, and Loans
COVID-19 is not yet a reason for distribution from a retirement plan, even though Congress continues to work on a relief package and the Senate proposal would allow penalty free withdrawals from 401(k) plans of up to $100,000 due to the effects of COVID-19. Generally, a defined contribution plan, such as a 401(k) or profit-sharing plan (Plans), only allows plan money to be distributed for a distributable event, such as a separation from service (retirement, termination, death, or disability) with the employer. However, these plans may also permit distributions while employees are still employed. These in-service distributions can be unrestricted or restricted by age or service as well as restricted to relieving a financial hardship of the employee. Similar rules apply to 403(b) and 457(b) plans. In-service distributions are not permitted in pension plans such as defined benefit plans and money purchase pension plans. In-service distributions are taxable, and if the employee is under age 59 ½, they are subject to an additional 10% federal penalty tax for early withdrawal.

Plans can also permit employees to borrow against their vested account balance under the plan. These are not considered distributions because they must be paid back. However, if an employee defaults on paying back the loan, it is then considered a distribution.

If an employer’s Plan permits in-service distributions, employees may access such funds to help alleviate the economic stress caused by COVID-19. Of course, the plan’s terms will govern. If the employer’s plan does not currently permit in-service distributions, the employer could amend the plan to include them.

In-Service Withdrawals
A Plan may permit in-service distribution of an employee’s salary reduction contributions after attaining age 59 ½. Plans may permit in-service distributions of employer contributions such as matching or profit-sharing contributions at an earlier age, but most adopt the same age 59 ½ requirement.

Hardship Withdrawals
A Plan can permit participants to make withdrawals if they are experiencing a financial hardship. The consequences of COVID-19 causing financial hardship upon employees may qualify for a hardship withdrawal. If permitted, the Plan will provide that, if the employee demonstrates that the withdrawal is needed to satisfy an immediate and heavy financial need, a withdrawal can be made of an amount sufficient to satisfy such need.

Most Plans have adopted a safe harbor whereby certain events are deemed to be “heavy and financial needs.” These are: medical expenses; educational expenses; rent, mortgage payments and other expenses to prevent primary residence eviction; expenses for principal residence repair; expenses for purchasing a principal residence; funeral expenses; expenses and losses such as income loss because of a federally declared disaster if the employee’s principal residence or place of employment are within the disaster area. A Plan can allow withdrawals for some or all of the above or outside the safe harbor for any demonstrated immediate and heavy financial need.

Importantly, while COVID-19 is a declared national emergency, it is not a declared national disaster yet. However, the President has declared California, Washington, and New York as major disaster areas. These declarations should qualify residents of these states and employees of employers in those states for a hardship distribution for losses as a result of the virus, if the plan has adopted the federal disaster safe harbor mentioned above.

Additionally, if an employee’s hours have been cut due to the employer’s business closing or reducing operation during COVID-19, but they have not been terminated, the employee will likely qualify for one of the other safe harbor events such as preventing eviction or foreclosure, or medical expenses.

An employee must take any distributions available under the Plan and other employer plans to try to relieve the hardship prior to a hardship withdrawal. Thus, if the employee is over age 59 ½ and allowed to take an in-service withdrawal without providing a reason, the employee must take such distributions and not a hardship distribution. Likewise, if the employee has actually been terminated, a hardship withdrawal is not available because at that point, the entire vested account balance is available for distribution.

Plans (and money purchase pension plans) can permit employees to borrow the lesser of $50,000 or 50% of the employee’s vested account balance. If that balance is below $20,000, the plan may, but need not, permit a loan of up to $10,000. The loan program must be authorized in the written plan document.

Loans must be in writing and bear a reasonable interest rate. But the loan is an investment of the employee’s plan account and the interest is credited to the plan account. So, the borrower is paying the interest to his or her own account. Loans must be paid back over no more than five years, unless it is for the purchase of a primary residence. Loan payments must be made at least quarterly.

A plan loan, if permitted, could be a good alternative to an in-service distribution to help employees during these difficult times. Most plans provide for repayment through payroll deduction but if the employee has insufficient earnings to make the payment due to a temporary cut in hours, the employee could write a check to the plan. Loan proceeds are not taxable nor subject to the 10% penalty for early withdrawal provided the employee does not default on repayment. Another advantage over a withdrawal is that the money is paid back to the plan to be used for retirement. Once money is withdrawn for an in-service or hardship withdrawal, it cannot be returned to the plan.

The major drawback of a loan is that if the employee is subsequently terminated, most loans are considered immediately due, and if not immediately repaid, the outstanding balance is considered a taxable distribution. However, the employee can avoid paying tax on the outstanding balance by rolling over the same amount into another employer plan or IRA by the employee’s tax return due date, including extensions, for the year of the distribution.

Unless there is a legislative change making retirement plan money more accessible as proposed, in-service distributions, hardship distributions, and plan loans, if permitted, could be tools to help ease the economic burden on employees caused by COVID-19. However, other tools and programs should be used first and an employee should only tap into retirement money if absolutely necessary.


Copyright © 2020, Murphy Austin Adams Schoenfeld LLP. All rights reserved. Please be assured that we make every effort to make certain that the information contained in this alert is current at the time this email was delivered. Because laws and legislation are constantly changing, please contact us if you are unsure whether this material is still current. Nothing contained herein should be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended to be for general information purposes only. We assume no liability in connection with the use of the information contained in this article. Given the rapidly evolving nature of legal and governmental responses to the COVID-19 pandemic, unfolding events likely will supersede many of the issues discussed in these updates. We encourage you to contact our lawyers directly for the most current information and counsel regarding legal and governmental responses to the COVID-19 pandemic. Please contact us to answer any questions you may have.

Murphy Austin’s Labor and Employment Law Team
Please contact one of our team members if we can be of assistance.

Aaron B. Silva
916.446.2300, Ext. 3027

916.446.2300, Ext. 3010

Dennis R. Murphy
916.446.2300, Ext. 3072

Murphy Austin Adams Schoenfeld LLP 

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