Those who are committed to strengthening safety nets for economically precarious workers at modest revenue cost should look no further than Goldburn Maynard and Clint Wallace’s paper on hardship-related early withdrawals by employees from their 401(k)/403(b) qualified retirement plans. Employees who need to make an early withdrawal due to hardship are, by definition, encountering difficulties and have lower ability to pay. Nonetheless, as Maynard and Wallace describe, a subset of hardship distributees may be surprised by a mismatch in the law that can heap further hardship upon them in the form of penalties.
The mismatch occurs between two sets of rules: first, the “hardship distribution” rules addressed to qualified plans under Code subsection 401(k), which allow a plan administrator to permit withdrawals before the employee reaches retirement age and, second, the rules addressed to taxpayers under Code subsection 72(t), which apply a 10 percent “early withdrawal” penalty. The regulations under 401(k) list various safe harbored-payments that constitute an allowable hardship distribution in response to “immediate and heavy financial need” that cannot be satisfied using other resources. (Pp. 3-4.) These payments include those for medical care that would be deductible under Code subsection 213(d), costs related to the purchase of a home for the employee, tuition expenses for post-secondary education, as well as payments to prevent eviction or foreclosure, for funeral expenses, and for a natural disaster or casualty loss. (Pp. 3-4, 26.) However, those same safe harbored-payments are not fully mirrored in the subsection 72(t) penalty framework, which contains a divergent list that doesn’t include eviction and foreclosure, limits qualifying medical care expenses, and allows payment for post-secondary educational expenses only in the case of individual retirement account holders, not those who have 401(k)/403(b) qualified plans. (Pp. 30-31.) As a result, some hardship distributees fall between the cracks: “[d]espite qualifying for the hardship distribution safe harbor, [they can avail themselves of] no exception to this separate penalty…” (P. 4.)
This mismatch might seem like a minor issue likely to affect few employees, but those who are affected constitute a group that has revealed itself to be struggling to make ends meet. Maynard and Wallace cite 2019 IRS and GAO studies documenting that, among the 1.7 million who received about $17 billion in hardship distributions, there is a higher likelihood of having total retirement assets of $5,000 or less, being low-income or somewhat low-income, being African American or Hispanic (i.e., not “White, Asian or Other”), being less-educated, having a larger family, and being widowed, divorced or separated. (Pp. 23-24.) Of this group, a whopping 1.2 million paid the 10 percent penalty (P. 23); those who are penalized are “poorer and nonwhite taxpayers who have the smallest account balances.” (P. 6.) For those ensnared by the mismatch, the penalty is almost guaranteed to exacerbate financial precarity. As Maynard and Wallace write, “the taxpayers who fall into the gap between hardship distribution rules and early withdrawal penalties constitute the most vulnerable account holders.” (P. 25.)
One of the aspects of the paper that makes it so engaging is its profile of a mother of three called Tiffany (all names in the paper were changed to protect privacy), who was assisted by the Low Income Taxpayer Clinic at South Carolina Law (round of applause to Clint and each LITC law school!). Tiffany needed funds because she “had fallen behind on her housing payments and was facing eviction; the withdrawal was necessary to keep her and her three young children from becoming homeless.” (P. 3.) Luckily, Tiffany’s plan permitted hardship distributions (bafflingly, plan administrators are not required to offer them). (P. 27.) Tiffany was permitted to make an early withdrawal from her employer’s 401(k) plan in accordance with the hardship distribution rules that contain the eviction safe harbor. But she wasn’t told that the same rules didn’t apply to the 10 percent penalty, or that eviction payments were not covered. Thus, Tiffany found out at tax time that she was responsible for a 10 percent penalty on her early withdrawal.
Maynard and Wallace point out that the application of the 10 percent penalty in cases like Tiffany’s fails to advance the dual policy goals identified in the penalty provision’s legislative history. (Pp. 4-5.) First, the penalty is supposed to function as a commitment device to prevent employees from shortsightedly draining their retirement savings. (P. 37.) However, it could not work as a deterrent in this regard for Tiffany: she gained knowledge of the penalty only after taking the action that triggered it, and was operating under the impression that she was not subject to the penalty because of her hardship situation. Second, the penalty is designed to recapture tax benefits that employees had reaped from having their savings grow tax-free in the qualified plan. (Pp. 4-5.) But because a low-income employee like Tiffany would likely be subject to the statutory zero percent rate on long-term capital gains, the penalty put Tiffany in a worse position than if she had forgone the use of her 401(k) entirely (Maynard and Wallace walk through an enlightening numerical example specific to low-bracket taxpayers). (Pp. 24-25.) The only thing it accomplished was raising a small amount of revenue from someone who could ill-afford to pay and understandably might feel misled by the mismatch.
Maynard and Wallace make a strong case that the IRS and Treasury, without any action by Congress, should improve communication, including using better vocabulary, about these two closely-related sets of rules. (Pp. 10-11, 39-40.) They argue that the use of clearer language would help employees understand that receiving approval for a hardship withdrawal is insufficient for waiving the penalty. On the legislative front, they propose a detailed set of reforms, two of which I’ll highlight. First, they recommend adopting a default income tax withholding obligation for plan administrators to avoid saddling employees with surprise tax bills. Second, they propose harmonizing the hardship withdrawal and penalty rules so that the same criteria that permit a plan administrator to make a hardship distribution could waive the early withdrawal penalty. (P. 36.) They point out that this has been accomplished to some extent by SECURE Act 2.0’s adoption of a $1,000 penalty-free hardship withdrawal provision (see recently-released Notice here), but Maynard and Wallace take issue with the meagre permitted amount.
As a supplement to this for the most vulnerable employees, they propose a resource-based waiver of the early withdrawal penalty in the case of a hardship distribution; their preferred approach is to offer a penalty waiver to those with lower total retirement assets. Here, the tricky part is defining what that means and addressing the discontinuity in treatment implied by a bright-line threshold. Moreover, they acknowledge that “this [resource-based waiver] approach might curtail the commitment device effect of the penalty for some.” (P. 37.) In not advocating for the abolition of the penalty in the case of all hardship withdrawals, the authors seem to endorse the commitment function of the penalty, even in the case of hardship, for better-resourced employees. However, they argue, eliminating the hardship withdrawal penalty for under-resourced employees may augment the propensity of this population to use the qualified plan vehicle for retirement savings “by giving some employees comfort that they can make contributions without later suffering consequences of depositing funds in an account [that is] out of reach in case of emergency.” (P. 37.) This is ultimately an empirical question and it would be fascinating to test this via an experiment or other study.
The article concludes by linking the maladies of the qualified plan hardship distribution regime with the larger themes of complexity, uncertainty, and unworkability in U.S. retirement saving policy for those with lower incomes. As the authors point out: “401(k) plans have been designed with an expectation that individuals can make and stick with long-term commitments, consider the time value of money, evaluate different investment options, and shoulder the burden of significant uncertainty about their investment decisions and their future preferences—all dubious expectations in the real world.” (P. 19.) Few will come away from this work unconvinced that low-income employees, and particularly those who are experiencing hardship, are poorly-served by the status quo retirement savings system.
