July 27, 2008 - I saw your recent column regarding borrowing from retirement plans. My husband and I have recently incurred major medical expenses. Is it possible to withdraw funds from my 401(k) plan because of a financial hardship?

Hardship distributions involve three issues: (1) whether a distribution can be made under the rules; (2) how much can be distributed; and (3) the tax results of the distribution.

In general, there are only two ways for active employees who are under age 59 1/2 to tap their account balances in 401(k) plans: take a loan from the plan; or take a hardship withdrawal, if they are eligible to do so. A distribution is treated as made after an employee's hardship only if it is made "on account of" the hardship, which in turn requires that the distribution: be made on account of an immediate and heavy financial need of the employee; and be necessary to satisfy that financial need.

In general, the question of whether an employee has an immediate and heavy financial need is based on all relevant facts and circumstances. A financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee.

Under a safe harbor rule, the regulations treat a distribution as made on account of an immediate and heavy financial need if made for:

(1) expenses for medical care that would be deductible under Code Sec. 213(d);
(2) costs directly related to the purchase of a principal residence for the employee;
(3) payment of tuition, related educational fees, and room and board expenses, for up to the next 12 months of post-secondary education for the employee, or the employee's spouse, children, or dependents;
(4) payments necessary to prevent the employee's eviction from his principal residence, or foreclosure on the mortgage on that residence;
(5) payments for burial or funeral expenses for the employee's deceased parent, spouse, children or dependents; or
(6) expenses for the repair of damage to the employee's principal residence that would qualify for the Code Sec. 165 casualty deduction.

A distribution won't be treated as necessary to satisfy an employee's immediate and heavy financial need to the extent:

(1) it exceeds the amount required to relieve that need; or
(2) the need may be satisfied from other resources that are reasonably available to the employee.

This determination generally is based on all relevant facts and circumstances. The employee's resources are treated as including assets that are reasonably available to him from his spouse and minor children. Thus, for example, a vacation home owned by the employee's spouse generally will be deemed a resource of the employee. However, a child's assets held in trust or under a uniform gifts to minors act aren't counted. The amount of an immediate and heavy financial need may include amounts needed to pay taxes or penalties reasonably anticipated to result from the distribution.

A hardship distribution can't exceed the maximum distributable amount (MDA). The MDA includes the employee's total elective contributions on the distribution date, reduced by any previous distributions of elective contributions. It also may include employer contributions depending on how those contributions are made (i.e., matching or nonelective), and how the plan is organized.

For example, a plan may provide that the MDA consists of elective contributions and the vested portion of employer matching contributions.

Unfortunately, there's no special tax break for hardship distributions where the employee hasn't made any after-tax contributions. They are includible in gross income, and may be subject to an additional 10% premature withdrawal penalty tax to boot, unless the exception for deductible medical expenses is met. Also, withdrawing funds from an IRA may be a better choice if it would avoid the 10% penalty, e.g., because of the exception for education-related withdrawals.

In conclusion, getting a hardship distribution from a 401(k) plan isn't easy, and shouldn't be used as a way to raise needed cash if other sources are available.

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