Some employers, however, seek to protect employees and only allow loans for limited purposes, and other employers even restrict hardship distributions. In today’s economic climate, it is important to understand the basic rules in making business decisions to allow or not allow such distributions.
A distinction must be made between employee salary reduction contributions and other employer contributions. Initially, prior to age 591/2, employees may only access their salary deferral contributions in the event of a hardship. Otherwise, employee salary reduction contributions must be obtained through a loan. Even access to employee savings contributions is limited.
Employees may be given access to employer matching and discretionary contributions under different rules. Many plans already provide access to these contributions after age 591/2. However, employees may be permitted to receive distributions of employer contributions prior to age 591/2 under a frequently forgotten rule.
In Revenue Ruling 68-24, the IRS said employees may be given access to contributions in a qualified retirement plan if the contribution had been in the plan for at least two years or if the employee had been a participant in the plan for at least five years. In order for these distributions to be made without violating the two-year/five-year rule, employees were precluded from participating in the plan for a six-month period after receiving a distribution.
However, the six-month exclusion rule is not required by statute, and many individually designed plans do not impose a suspension of benefits. Employers may wish to amend their plans to provide greater access to funds, if necessary, to help employees survive current economic losses.
The advantages and disadvantages of permitting employee access to employer contributions are as follows:
Advantages
• Employees may have access to funds in their accounts for legitimate purposes, which may not otherwise satisfy the hardship distribution rules and for which a loan is not desired.
• Employees may withdraw funds and rollover such amounts tax-free to an IRA to obtain greater investment flexibility than might be available under the employer’s plan.
• Access to investing retirement assets is usually the primary reason for use of in-service distributions.
Disadvantages
• Distributions will generally be subject to a 10% excise tax if paid prior to age 59½.
• Employees may squander all of their retirement benefits prior to retirement, thereby defeating the purpose of a retirement plan.
• Many prototype retirement plans do not permit in-service distributions under the two-year/five-year rule. Thus, amending a plan to contain such a provision will convert a plan to an individually designed plan. Obviously, mutual funds and other financial institutions are not anxious to permit distributions, which would deplete assets under their portfolios.
In addition to the employee savings and employer contributions noted above, access to after-tax and rollover contributions must be considered. Although employees may have access to these benefits at any point in time, consideration must be given to the purpose of a retirement plan. To the extent after-tax contributions exist, a portion of all distributions will be both taxable and nontaxable, which must be explained to employees.
Employers are encouraged to evaluate the objectives they wish to achieve and their employees’ needs, rather than the simplicity of packaged programs, when making valid plan design decisions, such as whether or not to allow various in-service distributions. —F.P.
Contributing Editor Frank Palmieri is an employee benefits attorney with Palmieri & Eisenberg in Princeton, N.J. and Alexandria, Va., and a fellow of the American College of Employee Benefits Counsel. He has more than 25 years of experience addressing employee benefit and employment-related matters for employers.
