When Deferrals Don't Stop After a Hardship Withdrawal.
Summary paragraph: Getting back on track after hardship withdrawals
ERROR: A plan participant takes a hardship withdrawal from his qualified retirement plan account, yet his salary deferrals continue. If the 401(k), or 403(b), plan has adopted a safe harbor definition of hardship withdrawal, it is in violation of Treasury Regulation 1.401(k)-1(d)(3), which requires that participants wait six months from receiving a distribution to resume contributions. The error is an operational failure, meaning the plan is failing to operate within the terms of the plan document. According to Ilene Ferenczy, managing partner with Ferenczy Benefits Law Center LLP in Atlanta, most qualified plans are indeed safe harbor hardship withdrawal plans and so must enforce the six-month suspension.
CONSEQUENCE: For plans that fail to comply on a large scale, the Internal Revenue Service (IRS), if discovering this on audit, could disqualify the plan. Then, all vested participant deferrals and earnings are subject to income tax; tax deductions on employer contributions to the plan are lost; and the plan trust itself would be subject to income tax.
CORRECTION: It is far likelier, however, that the IRS would calculate a percentage of the total deferrals and earnings and the employer be told to pay this negotiated sanction through the agency's Employee Plans Compliance Resolution System (EPCRS) Audit CAP-or, Audit Closing Agreement Program, says S. Derrin Watson, an attorney with the Relius division of FIS in Santa Barbara, California. In either example, the sponsor would also need to restore participants' accounts to where they were before the failure, he says.
If the sponsor spots the failure before an audit, it may be fixed through one of the other arms of the EPCRS-its Self-Correction Program (SCP) or Voluntary Correction Program (VCP). The sponsor has two years from the calendar year in which the problem began to self-correct. After that, it must seek the IRS' help, via the VCP, to work out a correction strategy.
For insignificant failures-say, one or two participants making impermissible deferrals for less than a year-sponsors have essentially unlimited time to self-correct, Watson says. Additionally, they do not need to report these failures.
As to specific corrections, none are spelled out by the EPCRS, therefore, its rules concerning excess allocations apply, Watson says. "[Under those rules,] the plan returns the deferrals, plus any earnings, from the day they were contributed to the day they are distributed. On the 1099R, you would put down Code E, meaning the money is taxed in the year it is returned or distributed. There's no 10% penalty tax for early distribution."
Ferenczy agrees, noting a second option: "It's possible that a plan could do 'rough justice' by moving the deferrals and earnings to a forfeiture account and then pay the participant the unpaid compensation from the company. This is likely done on many occasions, but I think the IRS would prefer the first option."
Another drawback, Watson notes, "This approach results in overpayment of payroll taxes and doesn't work at all
for Roth deferrals."
If the employer contributes a match, the correction grows more complicated. According to the terms of the plan, if the match is fixed, the employer deducts the amount and any earnings from the account, placing the money in its unallocated, or expense, account to be used for future contributions, Watson says.
PREVENTION: An uninformed payroll department is usually the cause of continued deferral failures. Plan sponsors should check their plan documents to see if procedures exist for shutting off deferrals upon hardship distributions-and for restarting them after six months. If not, such procedures should be added, and followed, both experts say.