(b)lines Ask the Experts – Participant Tax Implications of Taking a Hardship Withdrawal

“I am the director of benefits at a small 501(c)(3) organization that sponsors an Employee Retirement Income Security Act (ERISA) 403(b) plan. An employee who took a hardship distribution last year complained about a ‘massive’ (her words) tax bill when she filed her 2018 tax return recently. I was a bit surprised by the negative reaction, but do not have a lot of experience with hardship distributions, since we require that loans be exhausted first. I didn’t quite know what to say to her. Can hardship distributions indeed leave someone with a ‘massive’ tax bill?”

Stacey Bradford, Kimberly Boberg, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, vice president, Retirement Plan Services, Cammack Retirement Group, answer:

A hardship distribution can have severe tax consequences for a plan participant, particularly when the distribution is large. The reason for this is twofold:

1)   A hardship distribution is taxed not only as ordinary income (similar to compensation on an employee’s W-2), but there is generally a 10% penalty if the employee is younger than 59 1/2. So, for example, if the employee is in the 22% tax bracket, the hardship distribution would generally be taxed at the rate of 32% (or $3,200 on a $10,000 distribution). And that doesn’t even count state and local taxes, which are generally owed on a hardship distribution as well. Also, the larger the distribution amount, the more likely that the amount could result in income that would be taxed in a higher marginal tax bracket, thus increasing the tax liability even further.

2)   Unlike other types of retirement plan distributions, mandatory 20% withholding is not required for hardship withdrawals, though many recordkeepers will withhold 10% of the distribution unless a participant elects otherwise. This type of withholding is similar in concept to payroll withholding, where taxes are withheld in advance of when they are actually due so that the participant does not have to pay a huge tax bill at the end of the year. However, when participants only receive 10% withholding on their hardship distribution, many erroneously think that that is the ENTIRE amount of the tax that they owe, so they are unpleasantly surprised when they are taxed further on the hardship distribution when they file their income taxes.

It is for these reasons that recordkeepers often issue explanations of the tax consequences prior to the issuance of a hardship distribution. As the new proposed regulations may increase the frequency of hardship distributions, such communication will become increasingly important so that participants avoid any unpleasant surprises at tax time.

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.