401(k) Plans in the Age of COVID-19 – Hardship Withdrawals, Loans, Contributions, and Other Issues

In the midst of the global health crisis generally known as the “Coronavirus” or “COVID-19,” employers and employees alike are faced with challenges that would not have seemed imaginable only a month or so ago. In this regard, employee benefit plans, including 401(k) retirement plans, present their own unique issues. This article explores hardship distributions, plan loans, contributions, and other issues in association with the present crisis.

NOTE: On March 27, 2020, President Trump signed the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act, which contains provisions affecting 401(k) retirement plans, including expanded access to penalty-free withdrawals, temporary increases in the amount of money available as plan loans, and suspension of the required minimum distribution rules for 2020. Some of these new rules supersede or augment the discussion contained in this blog. For a discussion of the CARES Act rules applicable to 401(k) plans, see “Congress Passes CARES Act in Response to COVID-19 Crisis, Contains 401(k) Ease-of-Access and Other Provisions” available here.

Hardship Withdrawals in the Age of COVID-19. 401(k) plans are meant to be retirement vehicles and, as such, there are penalties for taking money early or for non-retirement purposes. In particular, the Internal Revenue Code imposes a 10-percent penalty tax on amounts taken from a 401(k) plan prior to a participant’s attainment of age 59 ½, unless certain exceptions apply. One of these exceptions is for distributions made on account of certain “hardships.” Hardship distributions (also known as hardship withdrawals) must meet a number of statutory and regulatory requirements in order to avoid being subject to the penalty tax (and they are still taxable as regular income). On September 23, 2019, the IRS issued final regulations on hardship withdrawals.

Generally stated, if a 401(k) plan so provides, a hardship withdrawal may be taken from a participant’s elective deferral account due to an “immediate and heavy financial need.” The amount of withdrawal is limited to the amount necessary to satisfy the financial need. The money is taxable to the participant and does not have to be repaid to the participant’s account.

Federally Declared Disasters. The final regulations referenced above contained a new safe harbor hardship distribution event — losses related to a federally declared disaster. Under the new safe harbor, a 401(k) plan participant is deemed to have suffered an “immediate and heavy financial need” if the participant incurs expenses and losses (which can include loss of income) as a result of a disaster declared by the Federal Emergency Management Agency (“FEMA”), provided the employee’s principal residence or principal place of employment at the time of the disaster was located in an area designated by FEMA for individual assistance.

At this time, the COVID-19 crisis has not been declared a “disaster” (although President Trump declared an “emergency” under the Stafford Act on March 13, 2020). As such, until FEMA declares a “disaster” with respect to COVID-19, the safe harbor cannot be specifically relied upon – but this could of course change.

Immediate and Heavy Financial Need? Nevertheless, even in the absence of the safe harbor, if a participant can reasonably demonstrate that he or she has suffered an “immediate and heavy financial need,” and that the amount of the withdrawal is necessary to meet that need, then he or she may be able to take the hardship withdrawal – regardless of whether or not the underlying reason is directly connected to the COVID-19 crisis. Assuming the plan relies upon the safe harbor criteria spelled out in the regulations (see “Observation,” below), two of these criteria are “unexpected medical expenses” and “burial and funeral expenses.” Accordingly, for example, unexpected medical expenses caused by a participant’s having contracted COVID-19 could qualify as an “immediate and heavy financial need” for hardship withdrawal purposes, even in the absence of a federal disaster declaration.

OBSERVATION: Whether a participant has suffered an “immediate and heavy financial need” for plan purposes often depends on the language contained in the plan’s hardship withdrawal provisions. Some plan’s strictly limit hardship withdrawals to the safe harbor circumstances laid out in the regulations, whereas other plans take a more liberal approach.

IMPORTANT: The above discussion is rendered somewhat moot now that the CARES Act has significantly expanded access to penalty-free withdrawals for participants directly affected by COVID-19. See “Congress Passes CARES Act in Response to COVID-19 Crisis Contains 401(k) Ease-of-Access and Other Provisions” available here for details.

For a more detailed discussion on hardship distributions, visit our previous blog here.

Plan Loans. Most 401(k) plans permit participants to borrow from their plan accounts. Under the general rule, the maximum amount that an individual may borrow from his or her 401(k) plan account (reduced by the outstanding amount of any previous loans taken from the plan) is the lesser of:

• $50,000; or
• 50 percent of the vested amount of their plan account balance.

IMPORTANT: The CARES Act temporarily increases the $50,000 figure to $100,000, and the 50 percent figure to 100 percent of the account balance, for participants directly affected by COVID-19. See “Congress Passes CARES Act in Response to COVID-19 Crisis – Contains 401(k) Ease-of-Access and Other Provisions” for details.

In general, plan loans may be taken for any reason. As such, participants who have been negatively impacted by the COVID-19 crisis may be able to access their 401(k) plan accounts by means of loans, if they have available funds in the plan.

CARES Act Repayment Relief. Plan loans must be repaid over a pre-determined schedule, not to exceed five years, except in special circumstances. Notably, the CARES Act contains a special provision related to COVID-19 — if any plan loan repayment is due between March 27, 2020 and before the end of the year, then the repayment may be delayed for one year, measured from the original due date. Subsequent loan repayments must be adjusted to reflect the delay in the 2020 repayment (including any interest accruing during that delay). The one-year delay for 2020 is disregarded for purposes of the generally applicable five-year limit on loan repayments.

OBSERVATION: Any time 401(k) plan account balances are reduced for any reason, there is less money remaining to accumulate investment earnings. Due to compounded interest, the effect on dollar amount of savings available at retirement age can be significant. As such, 401(k) plan loans should be used sparingly. Nevertheless, plan loans are usually a better idea than hardship withdrawals, or other in-service withdrawals (such as those taken on or after attainment of age 59 ½, if the plan document permits), as at least plan loans are eventually repaid.

For more information on 401(k) plan loans generally, please see our previous blog here.

Timing of Making of Employer Contributions. Although not part of the CARES Act, the IRS separately announced in Notice 2020-18 and related Q&As that, because the Federal income tax filing date has been moved to July 15, 2020 in response to the COVID-19 crisis, the deadline for making contributions to defined contribution pension plans (including 401(k) plans) is also extended. In other words, 401(k) plan sponsors now have until July 15, 2020, (as opposed to April 15, 2020) to make their 401(k) contributions for the 2019 plan year.

Miscellaneous Considerations. The following additional considerations, that are not necessarily specific to the COVID-19 crisis but could arise within its context, are briefly discussed below:

Mid-Year Amendments to Safe Harbor Plans. Employers who find themselves short of cash may wish to amend their safe harbor plans midyear to eliminate the safe harbor contribution. Although this is now generally permissible, there are a number of important considerations to take into account:

• Participants must be given at least 30-day’s advance notice before the discontinuation of safe harbor contributions can become effective.
• Removing the safe harbor feature will subject the 401(k) plan to nondiscrimination testing (ADP and ACP testing) for the entire plan year. This could pose a problem, if, for example, the safe harbor provisions had been adopted specifically because there was concern that the plan might not pass these tests, due to demographics or some other reason.
• If applicable, the plan sponsor may be required make a top-heavy minimum contribution for non-key employees employed as of the end of the plan year.

For a more detailed discussion of safe harbor plans, see our previous blog here.

Suspension of Other Employer Contributions. Employer contributions to 401(k) plans generally fall into two categories – matching contributions (typically, these match 50 percent or more of participants’ elective deferrals) or nonelective contributions (all participants receive them regardless of whether or not they make 401(k) elective deferrals). These contributions, in turn, are usually either mandatory or discretionary, depending on the terms of the plan. Matching contributions are much more likely to be mandatory, whereas nonelective contributions may be either mandatory or discretionary; that is, the company may elect to make them during a profitable year, or else elect not to make them during financially lean times.

The general rule is that if the contributions are discretionary, then the company may elect not to make them, without formally amending the plan. The opposite is true if, under the plan document, the contributions are mandatory (for example, if the plan states that “for each plan year, the company shall make a contribution equal to . . .”).

NOTE: Although, under the plan language, employer contributions may be discretionary, some courts have held that, in certain circumstances, a pattern of repeated annual contributions may become a “de facto” promise to employees. When eliminating or reducing an employer contribution for a particular year, where there have been contributions in preceding years, proper employee communication is critical to help avoid misunderstandings and potential litigation. Please consult your ERISA attorney or other qualified professional advisor if you believe this applies to your plan.

Segregation of Employee Deferrals. Importantly, there is no change to the rule mandating that employee 401(k) deferral contributions be made as of the earliest date that they can be reasonably segregated from general assets – in other words, employers must segregate all 401(k) deferrals from their general assets as soon as administratively possible. And, of course, diverting employee deferrals for any other purpose, however temporarily, is never permissible – it is a prohibited transaction, a plan disqualifying event, a possible lawsuit, and – worst of all – a crime!

For more details, our previous blog is available here.

Lay-offs and Ability to Take Plan Distributions. Generally, a lay-off is considered a separation from service and is treated as any other termination of employment for purposes of 401(k) plan distributions. (For example, laid off employees generally can collect unemployment insurance.) Accordingly, a laid-off employee is treated no differently than a permanently terminated employee, and can take any distributions available to other terminated employees.

If a participant is laid off and is later rehired, then, of course, he or she can no longer take a termination distribution.

If a laid off employee takes a distribution and does not roll it over to an IRA or another qualified retirement plan, then the amount of the distribution is subject to ordinary income tax, mandatory 20% tax withholding, and, depending on the participant’s age, a possible 10 percent early withdrawal penalty tax.

Click here for more information on 401(k) plan distributions.

Rehires and Plan Eligibility for Participation. If a laid off employee was already eligible to participate in the 401(k) plan at the time of the lay-off (even if not making elective deferrals), then he or she will be eligible to resume plan participating, without waiting for the next entry date.

If a laid off employee had not yet satisfied the plan’s eligibility requirements, then any service he or she completed prior to the layoff will most likely have to be counted towards meeting the eligibility requirements. Here, the specific plan terms, and the length of the employee’s pre-layoff service and of the layoff itself, will be critical factors in making the determination.

For more information on 401(k) plan eligibility, click here.

Twenty Percent “Reductions in Force.” Finally, note that, if more than twenty percent of an employer’s work force suddenly becomes ineligible to participate in a 401(k) plan because of a mass layoff, plan closing, or similar circumstance, a “partial plan termination” may be deemed to have occurred. This is generally a “facts and circumstances” determination, and it may occur in several steps rather than all at once. But if a partial plan termination does occur, then all plan participants must immediately become 100 percent vested in their plan accounts, and there may be other implications.

This is a complex subject, and if you believe your plan may be affected, we recommend that you consult your ERISA attorney or other qualified professional plan professional.

The information and content contained in this blog post are for general informational purposes only, and does not, and is not intended to, constitute legal advice. As always, for specific questions concerning your 401(k) retirement plan, or for help in operating your plan during the COVID-19 crisis, please consult your own ERISA attorney or advisor.