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Mastering A Difficult Conversation: Employee 401k Withdrawals

If an employee is in a situation of financial hardship, he/she may ask for either a hardship withdrawal or a loan. To begin with, it is essential to know the difference between the two.

A hardship withdrawal can be taken by an employee in times of “immediate and heavy financial need.” Hardship withdrawals limit the amount an employee can withdraw to just the amount needed to satisfy the financial need, plus income taxes. Unlike loans, a withdrawal does not need to be paid back. In fact, the employee is restricted from contributing unused, withdrawn dollars.

Qualifying for a hardship withdrawal is not just a simple process of asking for the money. The employee must provide documentation of at least one of the following situations:

  1. Medical expenses not covered by insurance
  2. The purchase of a primary residence
  3. Preventing eviction or foreclosure from primary residence
  4. Recovery from a catastrophe (such as a hurricane, flood or other natural disaster)
  5. Paying tuition/educational fees
  6. Burial or funeral expenses

Although in certain situations a hardship withdrawal may be the necessary option for a struggling employee, in many cases an employee will take a loan. A loan gives employees the ability to borrow the lesser of 50% or $50,000, from their 401k account, tax and penalty free. Loans are accompanied by an interest rate, decided on by the plan sponsor (most companies use the prime rate) and are always settled on a five-year payback schedule. Employees can continue contributing to their 401k account while they have a loan taken out. In general, loans are easier to obtain because they can be withdrawn “for almost any reason.” Along with this, there are no credit check requirements when applying for a loan – making this the prime target for employees looking to put some extra cash in their hands. The main risk of the loan is that employees must pay back the loan if they leave the company. If their account no longer covers the amount of the loan, this becomes an out-of-pocket cost to the terminated employee and is taxed as ordinary income and if taken prior to age 59 ½, may be subject to an additional 10% withdrawal penalty and possibly state income taxes.

Improper hardship withdrawals and unnecessary loans can negatively impact an employee’s financial security significantly. For this reason, it is essential that plan sponsors have tight criteria for when an employee can use them. For example:

  • Limit loan availability to hardship criteria.
  • Have an automatic restart policy for employees taking hardship withdrawals, once 6-month eligibility wait has terminated.
  • Provide multi-faceted education workshops, webcasts, and online tools.
  • Set requirements to request loans and hardship withdrawals in person before approval.

It is often in the employee’s best interest to avoid taking loans and hardship withdrawals unless one of the two is completely necessary. Some tips on how to potentially deter employees from taking out a loan or hardship withdrawal are as follows:

  • Plan ahead: Set a payoff timeline with the participant. Encourage them to pay off the loan earlier than five years*, and price out the per paycheck effect of taking the loan out. Write this on a piece of paper, and have the employee sign it.
  • Inform: Show the employee the effect of the withdrawal (link).
  • Inquire: Ask them the reason for requesting the loan.
  • Caution: Let them know about termination risk (60-90 days to pay off loan in full if terminated from employment). Loans not repaid are taxed as ordinary income and, if taken prior to age 59 ½, may be subject to an additional 10% withdrawal penalty and possibly state income taxes.
  • Explain: Describe the double-tax effect to them: The money you withdraw as a loan doesn't get taxed and loan repayments are made with after-tax dollars and distributions are taxed a second time when paid out for retirement.

If the employee has no other option than to take a loan or hardship withdrawal, it is essential to take the right approach when having this conversation with an employee about taking either a hardship withdrawal or loan. These five tips can help you during these uncomfortable conversations:

  1. Talk privately
    • Once you know that this is for either a hardship loan or withdrawal we’d suggest using a private meeting space.
    • Reassure the employee that anyone who is not directly involved will not have any knowledge of the situation.
  2. Be prepared
    • Know your plans rules and the laws surrounding loans and hardship withdrawals
    • Consider how an employee may react to the situation; the situation could very well become emotional and it is up to you to support them.
  3. Remain calm
    • A calm demeanor is important. If you handle the situation in a professional manner and are supportive of the employee they will find it easier to confide in and trust you.
  4. Be compassionate
    • Show the employee that you genuinely care about the situation and want to help them.
    • One of the best ways to show compassion is to listen attentively.
  5. Determine the next steps and follow up
    • Make sure that the employee is fully aware of the process and understands the decision they are making.
    • Be sure to check in to see if they have any additional thoughts or questions after the discussion has had time to sink in.

Obviously, it is impossible to predict the future; no one ever expects that one day they will fall into financial misfortune, forcing them to decide between delving into their retirement funds and continuing to suffer in the present. That is why when one of your employees finds themselves stuck between a rock and hard place it is best to deal with the situation with the utmost care and concern. Having these conversations can be difficult, especially because of how personal they can become. If you, as a boss, feel too uncomfortable taking this responsibility into your own hands it is also possible to ask your plan sponsor to have these conversations for you. Being well informed on the necessary information and having no relationship with the employee often makes it easier for them to take care of loans and hardship withdrawals.

 

This information is for general use with the public and is designed for informational or educational purposes. It is not intended as investment advice and is not a recommendation for retirement savings.

Michael Palumbos is a registered representative and investment advisor representative with Lincoln Financial Advisors Corp., a broker/dealer (member SIPC) and registered investment advisor offering insurance through Lincoln affiliates and other fine companies. Lincoln Financial Advisors Corp. and its representatives do not provide legal or tax advice. CRN-1845130-071217