Hardship Withdrawals - An Attractive Nuisance Becomes More Attractive

“Attractive Nuisance” – In the law of Torts, the attractive nuisance doctrine holds a landowner liable if the injury is caused by a hazardous condition that is likely to attract trespassing children or others who are unable to appreciate the risk involved.  For a child, think swimming pool.  For participants in a retirement savings plan, think hardship withdrawal.  

President Trump has signed the Bipartisan Budget Act of 2018 into law – avoiding another federal government shutdown. That law includes provisions that make hardship withdrawals more attractive – removing barriers, increasing available monies, and removing the suspension of contributions.  The provisions are effective for plan years starting after December 31, 2018:   

• Act Section 41113 deletes the six-month prohibition on contributions after a hardship withdrawal, and 
• Act Section 41114 adds two provisions:
  1. It expands assets available in a hardship withdrawal to include not only 401(k) deferrals, but to also include matching contributions and non-elective contributions, and earnings on those monies, and 
  2. It clarifies that participants need not first elect a plan loan before taking a hardship withdrawal.  

Why are hardship withdrawals an “attractive nuisance?”  The loss of retirement assets from a hardship withdrawal could be significant. Here’s how:  A worker, currently age 30, earning $48,000 a year, is contributing 6% of pay and receiving a 3% employer match.  He takes a $2,000 hardship withdrawal.  He currently has a 22% federal and 4% state marginal income tax rate – plus there is the 10% penalty tax for early withdrawal.  His net, net after taxes is $1,480.  Had he instead borrowed the $1,480, the six-month contribution suspension would not have applied.  Assuming a 7% rate of return until his age 67 Social Security Normal Retirement Age (SSNRA), avoiding the six-month contribution suspension would increase the account balance by ~$27,000.  The earnings on the avoided distribution of $2,000 would accumulate to ~$25,000.  That is a total of ~$52,000 - 35 times the $1,480 cash hardship distribution.  Of course, different assumptions generate different results.”

Some would argue that most workers only take hardship withdrawals as a last resort – a form of safety measure to address unforeseen circumstances.  Is that your experience as a plan sponsor?  

Others would argue that the law compassionately lowers the cost by eliminating the suspension of contributions.  That is true.  Without the suspension of contributions, the added earnings alone in the above example would have totaled ~$25,000 – “only” 16+ times the $1,480 he received!    

Some plan sponsors who are concerned about leakage have eliminated hardship withdrawals in favor of 21st Century plan loan processes – an improved form of liquidity designed to minimize leakage and maximize participant value. Importantly, plan loans are not leakage  provided they are repaid, and most are.  Defaults typically occur only where a loan is outstanding at separation.  So, adding 21st Century loan processes, features like “commitment agreements” and electronic bill paying, will reduce leakage. The leakage from defaulted loans will generally be less, much less than the leakage from hardship withdrawals.   

To the extent that plan sponsors continue to incorporate hardship withdrawal provisions in their plans, we support the changes incorporated in the budget act. The six-month suspension, in particular, is counterproductive to retirement preparation where workers decide a hardship withdrawal is necessary. However, the plan sponsor may continue to require participants to elect a loan before taking a hardship withdrawal. If you do implement these improvements to hardship withdrawal provisions, you may want to incorporate information in your financial wellness program about how hardship withdrawls impact retirement savings and wealth accumulation. 

Finally, before you take action, you will want to consult with your tax and legal advisors. You may want to reevaluate the efficacy of hardship withdrawals before making these changes. If your plan currently provides loans, you may want to engage with your service providers to ensure they have adopted a best practices loan process that will all but ensure repayment.  Adding loan features that include electronic bill payment will help your participants better prepare for retirement by reducing leakage – avoiding not only hardship withdrawals but also post-separation, pre-retirement distributions.  Electronic bill payment may also lower plan administrative expenses.   

We are providing this information to you solely in our capacity as individuals with knowledge and experience in the industry and not as legal advice.  The issues presented here may have legal implications, and we recommend discussing this matter with your legal counsel prior to choosing a course of action.  This publication was prepared to support the informational needs of the Plan Sponsor Council of America on the issues discussed.  The publication focuses on the needs of our association and the issues of interest to association members.  The publication is not and should not be used as  a substitute for legal, accounting, actuarial, or other professional advice.