Common Errors in Hardship Withdrawals

Tax Professionals' Resource
August 2, 2013 — 1,826 views  
Become a Bronze Member for monthly eNewsletter, articles, and white papers.

401(k) plans allow for withdrawal of some or the entire amount in a retirement fund in cases of emergencies before a person retires. Such withdrawals are known as hardship withdrawals. These withdrawals are subject to income tax as well as tax penalties from the Internal Revenue Department, generally to the tune of 10% of the withdrawn amount.

Document Errors

Documentation errors in hardship withdrawals can occur due to ambiguous provisions laid out in the plan that may be interpreted in different ways. Wrongly filled up forms during amendments and restatements of the plans can also give space for errors.

Suppose a company has a plan that allows hardship withdrawals in select cases such as family medical emergencies, family's educational purposes, and paying for residential property. The plan must state that an employee can only file for a hardship withdrawal if all other sources of money available to him such as insurance claims, loans, or asset liquidation cannot accommodate the expenses.

Suppose the provider intended the provision that a hardship withdrawal can be made to pay for residential property to cover only principal residence, but the provider does not specify so. Employees can make hardship withdrawals to pay for purchase or upkeep of additional residential property. This may include purchasing an apartment and renting it out, which would not be in line with the provider's intentions.

Keeping the provisions of the plan simple, clear, and precise is the best way to avoid documentation errors.

Errors Arising from Compensation Calculations

These kinds of errors generally occur due to miscalculation of the employee's contribution to a plan as defined in the guidelines of the plan. If the plan’s guidelines ask for the employee contribution to come from W2 wages, W2 wages is a very broad term. It encompasses all pay that is taxable including bonuses, stipends, cash awards, and benefits such as health insurance. Such ambiguous and misleading statements can give rise to error. 

Also, there is a cap for contributions to retirement plans set by the Internal Revenue Department. If there are errors due to underestimation of employee's contribution, the employer will have to make amends by contributing more to cover the missed contribution. If the compensation is overestimated, the employer must deduct the excess from the pool and the employee's contribution must be handed back to him.

Operational and other Errors

Operational errors are generally the result of poor understanding and implementation of the terms of the plan by the provider. Such errors can be prevented by understanding the documentation fully, and taking professional help to do so if needed. The next step is to make sure that all provisions in the plan are in line with the overall goal of the plan. If not, it would be necessary to change or revise the provisions that contradict the purpose of the plan.

If an employee neither states the purpose of the withdrawal nor provides documentation that all other sources have been exhausted, the application for hardship withdrawal should be turned down. If the conditions are overlooked and the withdrawal granted, it constitutes an operational error.

Tax Professionals' Resource