10 Attributes of Highly Successful 401(k) Plans.

10 Attributes of Highly Successful 401(k) Plans.

For the past 8 years, I have had the opportunity to help hundreds of plan sponsors to design and manage successful 401(k) plans. In my opinion, successful plans for small to mid-size employers typically display the following attributes.

1. The costs, fees and expenses of the plan are reasonable.

Understanding the importance of plan costs, expenses and fees is one of the most important duties of plan sponsors and fiduciaries. When asked about plan costs, some plan sponsors actually think their plan is free. This perception is most common when their providers are paid by hidden revenue sharing arrangements. 

One of the key services I provide to employers is an annual evaluation of overall plan expenses and a determination as to whether they are reasonable. Your plan is not required to be the lowest-cost in its peer group, but if your fees fall in the highest quartile, it is a red flag that cannot be ignored. 

In reality, receiving more and better services as well as retaining providers who are better positioned to help a plan achieve its goals are all valid reasons to pay a little more. Hiring a provider because he or she is a family friend or because they have provided personal financial services to the CEO or owner are not sufficient reasons and may in fact increase your fiduciary liability.

Finally, if you or your advisor is not actively monitoring plan costs and documenting the process, you need to begin to do so. To the regulators, process trumps results!

2. A high percentage of eligible employees participate in the plan.

Employers who sponsor 401(k) and other retirement plans such as defined benefit cash balance plans for their highly compensated employees have made a substantial investment of time and money to provide this benefit. The best plans should have at least 85% of eligible employees who are participating in making payroll contributions.

These plans are effective in communicating the virtues of saving for retirement. In addition, they usually feature generous employer matching contributions that incentivize participants and build in automatic enrollment options for newly eligible participants.

3. New employees roll money into the plan. Departing employees leave their balances in the plan.

The best plans have characteristics that set them apart. A plan that has an open-architecture platform which provides access to outstanding investment options and low cost share classes becomes a magnet for other retirement assets.

New employees who compare these lower cost options to “retail” IRA accounts with limited investment menus are eager to combine other qualified accounts with their company’s 401(k) plan. When these employees terminate employment, they are comfortable in maintaining their plan balances because they view management as a friend, not an enemy.

4. Employees understand the plan.

The best plans effectively communicate how the plan works to their employees. These companies are intentional in communicating the benefits of participating in their plan to both new recruits and to retain their best talent.

These employers include a clear and simple description of plan benefits, with emphasis on employer contributions, vesting schedules and professional advice available to participants. More importantly, employees who are on track to achieving their retirement goals become the strongest advocates for participation. 

5. The fund design and investment lineup has a home for everyone.

There are different types of investors in every plan.

Some want to be well diversified over the core funds lineup and need professional allocation tools to achieve a successful outcome.

Index investors are interested in utilizing low-cost index instruments in a variety of asset classes to properly diversify their accounts.

Some participants are opportunistic and look for unique specialty investments in the plan.

Finally, almost every plan has a high percentage of participants who don’t want to get into the weeds of investment allocation and prefer balanced, “do it for me” default options such as target date funds. 

In addition, many professional service organizations which I assist offer additional “hybrid” plans in addition to a traditional 401(k) to allow highly compensated members to boost their levels of tax-deferred savings. These individuals often find themselves behind in saving for retirement in their early 40’s or 50’s due to lower compensation levels and debt reduction needs earlier in their careers. Combining a defined benefit cash balance plan with the 401(k) becomes not only a significant tax saving tool for these members but an important competitive advantage in recruiting and retaining talent for their firms.

In most cases, the greater the number of participants in your plan, the broader and more flexible your investment menu should become.

6. The leaders in your organization talk about the plan.

This trait can sometimes be difficult to measure. Companies that care about their human capital and talent take personal pride in their benefits package. These leaders not only find a way to talk about the plan at official corporate gatherings, but plan benefits are featured as a recruiting and retention tool in their everyday conversations. Mobile apps for successful plans can be used to instantly demonstrate that leaders are not only engaged with the plan, but well on their way to a successful retirement.

7. The plan’s fiduciaries understand their role and document their decisions.

Most plan sponsors need some fiduciary education and guidance in what is expected from them. Many simply rely on their providers and trust in the myth that they can outsource all of their fiduciary duties. In reality, this attitude can be extremely dangerous. Many providers are not acting in a fiduciary role to the plan, including plan advisors who are affilliated with broker dealer firms. 

Plan sponsors should know and understand the details of their plan document and the disclosure notices which must be provided to participants. They should monitor plan investments and fees and have a process in place which documents these duties. If they do not have the knowledge or experience to carry out these responsibilities, they are required to hire experienced providers who do. In my experience, plan sponsors of the best plans have established a process for all of these important functions.

8. The investment advisor is a fiduciary and specializes in company sponsored retirement plans.

The best plans hire advisors who specialize in the expertise and functions most important to plan sponsors. These include plan design, creating Investment Policy Statements (IPS), selecting and monitoring of plan investments, provider search, monitoring plan expenses, fiduciary guidance and effectively communicating plan benefits to participants. In the best plans, the advisor usually takes a proactive role as the “point man” or plan quarterback.

Plans which hire advisors affiliated with broker-dealer firms are exposed to conflicts of interest which impact key decisions. If your advisor is paid based on revenue sharing arrangements with a mutual fund company or recordkeeper, you have a fiduciary duty to find a new provider.

9. Participants have access to tools and technology that help them stay on track to meet their goals.

Successful plan providers provide useful online tools that keep participants informed and on-track. Most recordkeepers today offer real-time access to participant information such as deferral rates, plan allocation tools, re-balance features and transparent fee disclosure. Mobile apps that allow participant access are now available from most recordkeepers. Advisory services that calculate  and project monthly retirement income allow participants to make more informed retirement choices.

10. The plan sponsors and advisor have a written Investment Policy Statement that guides investment decisions.

Although not specifically required by ERISA guidelines, the best plans have adopted a written Investment Policy Statement which defines the criteria for all investment decisions. Investment asset classes are defined in this document and based on the demographics and investment sophistication of participants.

As an example, our plans evaluate each investment by 11 different criteria such as manager tenure, minimum net assets, net expense ratios, style and composition, 1,3 and 5 year performance as well as measures of risk such as alpha and sharp ratios. When current investments fail to measure up to these standards, they are placed on a watch list for further evaluation or deleted and replaced.

The best plans employ a rigorous and disciplined approach to investment decisions and document this process on a consistent basis. It is important to understand that ERISA does not hold plan sponsors or providers to a performance standard in regard to investment returns. But it does emphasize that there is an investment process that is consistently adhered to by plan fiduciaries.

This is not a complete list!

In reality, there are probably additional attributes that are shared by the best 401(k) plans. However, I have found these ten attributes to be universally shared by successful plans.

Brian C. Rall

President – Strategic Retirement Partners, LLC

Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education for company sponsored retirement plans.

Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.

Share Class Matters in 401(k) Investment Lineups!

When it comes to 401(k), mutual fund class matters!

Normal practice for 401(k) plan providers is to offer an investment lineup of mutual funds in multiple share classes. All of these share classes hold the same underlying securities and management but are offered to investors with different fee structures. Although this may be a convenient method to compensate selling agents, brokers, and record keepers, employers are required to make the lowest cost shares available to their plan so that participant returns are not negatively impacted by avoidable expenses. 

Understanding the information available in a mutual fund prospectus and various fee disclosures is essential for employers to properly evaluate share classes offered to employees in a 401(k) plan. This information should be reviewed annually because mutual funds make frequent changes to share class fees. However, some basic education regarding mutual fund fees is necessary to properly complete this process.

Mutual Fund Fees: A Crash Course

Registered investment companies are compensated by charging both shareholder fees and operating expenses for their services. Shareholder fees apply to individual transactions and account maintenance while operating expenses are based on regular and recurring fund expenses. Mutual funds legally must be offered by a prospectus clearly disclosing these fees for all share classes, greatly simplifying the process of fee comparison for potential investors.

Shareholder expenses can include the following:

  • Sales loads: A fund offered with a sales load is basically a commission offered to a broker or agent. A “front-end” sales load reduces the amount available to purchase shares. A “back-end” or deferred sales load reduces the proceeds available from a redemption of fund shares.
  • Purchase Fees: These are similar to a front end sales load, the difference being that proceeds are paid to the investment company as opposed to a salesperson. The intent of purchase fees are to offset any costs involved in the purchase of shares.
  • Redemption Fees: In a like manner, these fees are similar to deferred sales loads, with the proceeds paid to the investment company to offset expenses involved with the sale of shares.
  • Account Fees: These are charged by some funds for falling below a minimum balance.
  • Exchange Fees: Some mutual fund companies may charge a fee for exchanging shares of a fund for those of a different fund managed by the same company.

Operating expenses can include the following:

  • Management Fees: These are fees paid out of assets to compensate the fund for portfolio management services.
  • Distribution and/or 12b-1 Fees: These fees are paid out of fund assets for the market or sale of shares, usually as compensation for brokers or agents who sell the fund’s shares. 12b-1 shares are named after an SEC rule that authorizes their use.
  • Other expenses: This category includes expenses other than those listed above. They can include transfer agent, legal, administrative and custodial expenses.

Revenue Sharing and 401(k) Investment Lineups

Mutual fund companies typically use share classes which include non-investment related fees to compensate agents of broker dealers and certain non-fee based advisors for including their funds within a 401(k) lineup. They are also utilized as a way to compensate other plan providers such as record-keeping firms and third party administrators. These compensating arrangements allocate a percentage of the total operating expenses charged by the mutual fund to plan participants in two general forms:

  • 12b-1 Fees. These payments are usually made to a broker in exchange for providing plan services and for simply recommending that the plan utilize a certain fund and share class. They are disclosed in the fund’s prospectus as “distribution and/or service 12b-1 fees.”
  • Sub-Transfer Agency Fees (also referred to as “Sub-TA” fees): These payments are usually made to a 401(k) plan recordkeeper to subsidize or pay for those services. They increase “Other Expenses” and are included in the fund prospectus as estimates. In order to determine the actual amount being charged against plan assets, employers must reference the annual 408b-2 fee disclosure prepared by the plan administrator.

These additional fee sharing arrangements are known in the 401(k) industry as revenue sharing. Funds that offer revenue sharing typically are offered in a greater number of share classes, with each share class paying a different rate. And because 12b-1 and sub-TA fees are not related to actual investment expenses, they are often buried in the fine print of  fee disclosures and fund prospectuses.

Share Classes and Investment Returns

To see the impact of various share classes on investment returns, I have included the following information from the November 1, 2019 prospectus for the Growth Fund of America, managed by Capital Research and American Funds Group.

Although this fund is offered in many additional share classes for individual investors, 401(k) plans usually include one of the 6 “R” share classes. I have shown only three of these 6 share classes below for purposes of illustration:

American Funds: The Growth Fund of America[1]

Management Fees0.270.270.27
Distribution/12b-1 Fees1.000.500
Other Expenses0.140.190.04
Total Annual Fund Operating Expenses1.41.960.31
Average Annual Total Returns-Lifetime[2]7.83%7.99%13.69%

As you can see from the above table, R1 shares pay the highest 12b-1 fees, while R6 shares pay none at all. That means that R1 shares of the fund have significantly higher operating expenses than those of the R6 shares due to the additional fees which are deducted from participants holding these shares. These fees are paid to brokers who provide certain services to the plan and its participants.

Revenue sharing arrangements among retirement share classes present a very real fiduciary issue for plan sponsors. The reason? Fiduciaries are required to make the least expensive fund shares available to their participants. And as illustrated below, revenue sharing arrangements within share classes often have a devastating impact on investment results.

R1 vs R6 Shares: Do the Math!

Let’s take a look at a comparison of a participant who begins saving $10,000 a year at age 30 and who continues to invest this sum annually in the American Funds Growth Fund of America R1 shares. At age 65, he/she would have accumulated a balance of $1,728,850 assuming that the shares compound at the current lifetime rate. On the other hand, had the participant been offered the same fund’s R6 shares with lower expenses, he/she would have accumulated a far greater balance of $6,909,670. This represents a jaw-dropping difference of $5,180,820! 

Employers Should Pay Attention to Share Class

When shopping for a 401(k) plan, employers should pay careful attention to share classes, since they have a meaningful and direct impact on retirement outcomes for participants. 

They should also avoid advisors or brokers who are compensated by revenue sharing arrangements such as 12b-1 fees, since clear and obvious conflicts of interest exist between those advisors and plan participants.

If you are an existing plan sponsor not sure how your plan providers are compensated, you need to take a closer look at what share classes are offered in your plan. You may be paying more than you should.

Today, there are multiple low cost, open architecture platforms that allow institutional and retirement share classes free from 12b-1 and sub-TA fees. If your platform does not, it may be time to switch to a new provider.

At Strategic Retirement Partners, we avoid revenue sharing fee structures and are paid a flat fee based on total plan assets. If you would like a free evaluation of your plan fees, give us a call. We can help!

Brian C. Rall

President – Strategic Retirement Partners, LLC

Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education for company sponsored retirement plans.

Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.

[1]Source: November 1, 2019 Prospectus, Growth Fund of America


SIMPLE, SEP or 401(k)? FAQ’s

SIMPLE, SEP or 401(k)? FAQ’s

I regularly get calls from legal firms, medical and dental practices and CPA’s looking to set up a company sponsored retirement plan. Not surprisingly, they usually want a plan that is simple to administrate and is low cost. Congress has established several types of retirement plans in addition to 401(k) that are intended to be easy for small businesses to implement and maintain. This article will attempt to highlight the similarities and differences between 401(k), Simplified Employee Pension (“SEP”) and Savings Incentive Match Plan for Employees (SIMPLE).

Although both SEP and SIMPLE plans require minimal documentation, no annual testing and limited government filings, each imposes some additional limitations that often lead to a regular 401(k) plan being a more cost effective solution.

The Size and Goals for Your Plan

Employers of any size are allowed to implement 401(k) and SEPs. SIMPLE plans are limited to companies of 100 or fewer employees with a minimum of $5000 compensation during the immediately preceding year. It is also important to determine whether the plan goals are to benefit more highly compensated partners and owners, or primarily to help rank and file employees save for retirement.

Exclusive Plans

A SIMPLE plan must be the only plan maintained by an employer in a given calendar year. This is important when transitioning a SIMPLE to a 401(k) plan in that the earliest a 401(k) can be established is January 1 of the subsequent year given that adequate notice of termination is provided to employees (not less than 60 days prior to year-end).

401(k) and SEP plans are not subject to this exclusivity restriction, allowing employers more flexibility to maintain multiple plans or to transition from one plan to another.


Flexibility in regard to eligibility requirements is a key feature of 401(k) plans, with employers allowed to restrict up to age 21 and completion of one year of service. A year of service is further defined as a twelve consecutive month period in which the employee works a minimum of 1000 hours.

In a SIMPLE or a SEP, this flexibility is lost. SIMPLE plans are able to limit eligibility to employees who have earned at least $5000 in compensation in the prior two years and are reasonably expected to do the same in the current year. There are no service eligibility exclusions. SEPs can limit plan coverage only to those employees who have earned at least $550 in compensation in at least three of the past five years. Importantly, there is no ability to exclude short-term or part-time employees if they meet this requirement. This often makes these plans more, not less, expensive for employers than a traditional or safe harbor 401(k).

Employee Contributions

Salary deferrals are not allowed in SEP plans unless they were established prior to 1997. While both 401(k) and SIMPLE plans allow employee deferrals, there are some critical differences.

The first is in regard to the limits to total annual deferral limits. A 401(k) participant is allowed to defer up to $25,000 per year ($19,000 plus an additional “catch-up” deferral for those age 50 or older). SIMPLE participants are capped at $16,000 ($13,000 plus $3000), a whopping $10,000 less than 401(k). Do the math! For business owners or partners in higher tax brackets, the tax savings alone often offset the additional cost of a 401(k) plan not to mention hundreds of thousands of additional retirement benefits at retirement age.

Employer Matching

Employer contributions are mandatory for SIMPLE plans, with the option of a match or profit sharing contribution. The match option is limited to 100% of the first 3% deferred by the employee. There are no additional matching contributions available.

401(k) plan sponsors, however, may elect a discretionary match, giving them flexibility from year to year whether to make a match and if so, how much. Employers who elect safe harbor provisions avoid certain non-discrimination testing restrictions by agreeing to a matching formula of 100% up to the first 3% deferred by participants, plus 50% of the next 2% deferred. This match is typically made each payroll, although some plans make a one-time match in the quarter immediately following year end. 

Since SEP plans do not allow employee deferrals, matching options are eliminated by design.

Employer Profit Sharing

Employers with SIMPLE plans can elect a mandatory profit sharing contribution of 2% of compensation for each eligible employee rather than making the required matching employee contributions. This makes it easier for many employers to estimate the total employer contributions required. 

Both SEPs and 401(k) plans allow discretionary profit sharing contributions of up to 25% of compensation, limited to the lesser of 100% or $56,000 in 2019. As an alternative to the tiered safe harbor match for 401(k) plans, a non-elective safe harbor profit sharing of 3% may be made on behalf of all eligible employees.

SEP contributions must be uniform, or pro-rata, for all eligible employees. An employer or owner contributing 10% of pay for himself or other key employees must also contribute 10% to each eligible employee. 401(k) plans on the other hand allow owners much greater flexibility to discriminate higher profit sharing allocations to those who earn more than the taxable wage base or target contributions based on job classification. These allocation options include age weighted, Social Security integration and new comparability. These profit sharing options make 401(k) a much more popular option for attorneys, physicians and dentists who benefit from the ability to maximize deferrals and tax savings.

Additional Tax Savings for Partners & Owners

In addition, a separate “cash balance” added to a traditional or safe harbor 401(k) plan may be established in organizations with strong and predictable cash flow and where owners, partners and other highly compensated employees wish to increase their annual pre-tax contributions. These plans enable certain targeted participants the ability to contribute up to a total of $280,000 annually, depending on age and annual compensation. I plan to discuss these plans in greater detail in future articles so stay tuned to the blog or give me a call for further details.

Vesting Considerations for Employer Contributions

A 401(k) plan can impose a vesting schedule of up to 6 years on employer contributions other than those which are designated as safe harbor. (All safe harbor employer contributions are immediately vested.) This can be an advantage to a plan sponsor who has higher turnover among its lower paid employees.

There is no such vesting flexibility with SIMPLE or SEP plans, making them less effective than 401(k) in regard to retaining key employees.

Loans and In-Service Withdrawals

401(k) plans are the only employer sponsored retirement plans that offer participant loans. 

A participant taking an in-service withdrawal from 401(k) prior to age 59 ½ are subject to regular income tax plus a 10% early withdrawal penalty. SEP distributions in most cases are treated similarly. Withdrawals or rollovers from a SIMPLE, if made within the first two years of participation, are subject to a 25% penalty. This potential negative impact should be factored in both to decision and timing of terminating a SIMPLE. 

Plan Documents

All of these plan types require some form of documentation. For plans that that can be standardized (i.e. no creative plan design, controlled or complex ownership) the IRS has forms available that you can adopt:

  • Form 5305 – SEP
  • Form 5304 – SIMPLE: This allows each employee the option of selecting his own custodian and financial institution. This means that a company of 10 employees may have to send contributions to 10 different custodians each pay period. This is clearly not simple!
  • Form 5305 – SIMPLE: Employer selects a single financial institution for all plan contributions.

Plans such as 401(k) or more customized SEP/SIMPLE plans typically adopt a pre-approved prototype format or an individually customized plan document. Many providers offer prototype plan documents that can appear to be straight-forward, but given the importance of the plan document, we recommend working with an advisor with expertise in plan design.

Annual Discrimination Tests

Both SEP and SIMPLE plans are exempt from most annual compliance testing, with the exception of minimum coverage requirements for SIMPLE plans. This is one of the reasons that administrative costs are lower for these plans.

A traditional 401(k) plan which has not adopted safe harbor matching or profit sharing provisions must comply with a series of compliance tests that ensure that employer contributions and the percentage overall invested assets associated with lower paid, rank and file employees are adequate. Although testing adds to administrative expense and complexity, the trade-offs for a well designed 401(k) plan may more than pay for this additional cost. Such trade offs include higher annual contribution limits and tax saving, employer profit sharing and lower investment fees. 

Government Reporting

401(k) plans of all sizes must file an annual Form 5500 report with the DOL each year. In addition, most plans with more than 100 employees are required to perform an annual audit of the plan, adding to administrative costs. Those plan sponsors with terminated employees which continue to maintain a balance in the plan must also file form 8955-SSA.

Neither SEP or SIMPLE plan sponsors are subject to these filing requirements. However, plan sponsors must monitor and comply with participant reporting requirements related to required minimum distributions at age 70 ½ and other in-service withdrawals. Because monitoring participant accounts with multiple custodians is next to impossible, compliance is a real headache for plan sponsors of SIMPLE plans.

Plan Investments

Although there a few exceptions, financial providers of SIMPLE plans often offer mutual funds with front end or deferred sales loads that may range as high as 5%. In many cases, they offer proprietary funds that are subject to revenue sharing arrangements that offer them additional hidden compensation. In short, participants are treated as retail accounts and therefore the quality of financial advice to participants is subject to the lesser standard of suitability. In contrast, the fiduciary standard for an experienced, fee-based 401(k) advisor is a much higher level of prudence. Finally, fee disclosure requirements for SIMPLE plans are not uniform and transparency can vary significantly  depending on the provider.

SEP plans are often invested in individual financial instruments subject to the restrictions of the plan document itself or the investment policies of the account. In most cases, participants do not self-direct their individual investment accounts or are offered standardized investment allocations with limited options to change during the plan year. As is the case with SIMPLE plans, fee disclosure transparency is often a huge downside.

Depending on the provider that you choose, 401K typically offers greater flexibility with regard to investment options. Although some bundled providers such as mutual fund companies or insurance companies offer more expensive mutual fund share classes or high-cost variable annuity products as turn-key solutions, there are many terrific, low-cost providers today who offer flexible “open-architecture” investment platforms. These designs permit lower cost, institutional share class funds and include both actively managed as well as passive index fund options that are superior to most of those offered through SIMPLE platforms. In general, plan sponsors should use only those providers that they understand and who are transparent about their fees.

Transitioning to 401(k) can offer significant investment cost savings both immediately and over longer time periods. Working with an experienced 401(k) advisor acting as a plan fiduciary is highly recommended to achieve both positive participant outcomes and a well-documented investment process.

What Plan is Right for My Practice?

There is no question that a company sponsored retirement plan offers significant benefits including individual tax saving, employee recruitment and retention of key employees. For most law firms, physician and dental groups, a well designed 401(k) offers these important employee benefits and pays for itself through tax savings at a fairly modest level of owner participation. 

For established firms or practices with highly compensated owners or partners who wish to contribute more of their compensation pre-tax for retirement, the addition of a defined-benefit cash balance plan can offer huge benefits and more than pay for the additional administrative expense. 

However, if your retirement plan goal is to offer a payroll savings plan which primarily motivates lower paid employees to save for retirement, a SIMPLE may be your best option, despite it’s clear limitations. On the other hand, if you are considering transitioning from a SIMPLE to a 401(k), you should understand the steps necessary to be compliant and attempt to avoid possible distribution penalties and rollover restrictions.

If you are shopping for a plan, give us a call. We can help you put the pieces together that will result in the best plan for you and your employees!

Brian C. Rall

President – Strategic Retirement Partners, LLC

Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education for company sponsored retirement plans.

Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.

401(k) Hardship Distributions: An Employer’s Guide to Proposed IRS Rule Changes.

401(k) Hardship Distributions: An Employer’s Guide to Proposed IRS Rule Changes.

Plan Sponsors Need to Understand the Hardship Rules

A 401(k) plan may allow participants who face certain types of financial stress or emergencies to request a distribution from their account balance. Allowing hardship distributions from your 401(k) may in fact be a plan feature that benefits certain participants who are financially distressed yet puts an added burden on plan sponsors to understand and properly implement IRS regulations. Failure to do so may subject them to severe consequences, including fines, penalties and plan disqualification. 

In November of 2018, the IRS proposed changes to hardship distributions, including how and under what circumstances they could be received by participants. Beginning in January of 2019, employers were allowed to implement certain of these changes prior to them becoming finalized by the IRS.

Since I am frequently asked questions regarding hardship distributions by plan sponsors, we thought it might be helpful to review  some of the most FAQ’s regarding these often misunderstood guidelines.

Are all 401(k) plans required to permit hardship distributions?

No. The decision to allow hardship distributions is an option available either when the plan is originally established or as an amendment to an existing plan. Keep in mind that individual plan demographics may work against allowing this feature if a higher percentage of participants may find themselves qualifying for these distributions.

What are the qualifications for a participant to request hardship distributions?

A 401(k) participant must satisfy two criteria in order to qualify for a hardship distribution:

  • He or she must have an “immediate and heavy financial need”.
  • The distribution should be limited to an amount necessary to satisfy that need”.

What is the IRS definition of hardship for a 401(k) plan?

In addition to the employee’s immediate and heavy financial need, the definition includes those of an employee’s spouse, dependents and beneficiaries. Employers are allowed determine certain qualifying events of hardship under two options:

  • Use the IRS Safe Harbor definition.
  • Use a custom definition.

In the great majority of cases, plan sponsors elect to use the Safe Harbor option which lays out 6 events which qualify as a participant hardship:

  1. Medical care for the employee, the employee’s spouse, dependent or beneficiary.
  2. Direct costs related to the purchase of an employee’s personal residence, not including the mortgage.
  3. Tuition, fees and room and board expenses for the next 12 months of post secondary education for an employee, an employee’s spouse, dependent or beneficiary.
  4. Payment necessary to prevent eviction or foreclosure on a participant’s primary residence.
  5. Funeral expenses for the employee, employee’s spouse, dependent or beneficiary.
  6. Certain expenses to repair damage to an employee’s permanent residence.

How do we calculate the amount necessary to satisfy the immediate financial need?

The IRS regulations make it clear that the distribution may factor in the impact of taxes and penalties that may result from qualified hardship distributions. In addition, employers should make the determination that the employee could not reasonably obtain liquid funds from any other source.

In addition, employers are allowed rely on the employee’s written statement that the need cannot be relieved from other resources, including insurance or other reimbursements, liquidation of the employee’s assets, the employee’s wages after termination of all elective deferrals and plan or “reasonable” commercial loans. 

What documentation should employers obtain as part of the hardship distribution application?

Employers are allowed to choose one of two options in regard to the proper documentation of all plan hardship distributions:

  1. Traditional Substantiation:

Under this method, employers obtain the actual source documentsthat substantiate the need. This is the only method that is acceptable for non-safe harbor hardship qualification.

  • Summary Substantiation: 

Employers rely on a written, participant-provided summaryof the hardship, provided that the summary includes certain, required information.

In every case, plan sponsors should retain these documents according to   the document retention rules established under ERISA.

What are the financial consequences of hardship distributions on participants?

Hardship distributions can have severe and significant financial impacts upon participants in that they are included in gross income unless they consist of designated Roth contributions. Participants who have not yet attained the age of 59 ½ are subject to additional penalties of 10%. Finally, because hardship distributions cannot be repaid to the plan or rolled into another qualified plan, the compounding impact of future lost income due to these withdrawals can be significant.

What are the IRS proposed rule changes to hardship distribution regulations?

The IRS implemented a number of significant changes to the current hardship regulations and issued a proposal draft in November of 2018 outlining the changes. Plan sponsors were allowed to implement these changes on January 1, 2019 or alternatively, they may choose to wait until the changes are finalized. 

The key changes in the current proposal are as follows:

  • Removal of the six month suspension rule following a participant distribution. Under current rules, participants are prevented from making contributions to the plan for a 6 month period. Employers have the option in 2019 to remove this suspension and are mandated to do so beginning January 1, 2020.
  • Current regulations limit the source of contributions eligible for distributions, excluding QNEC’s, QMAC’s, safe harbor contributions and earnings on elective deferrals. The new proposal lifts these restrictions. Implementation is optional, not mandatory.
  • Under current standards, participants are required to take a loan prior to requesting a distribution. The proposal eliminates this provision.
  • Employers currently must consider all relevant facts and seek relevant documentation. The proposal allows them to rely on written representations from participants that he/she has sufficient liquid assets to satisfy the need, unless the employer has knowledge to the contrary.
  • An additional qualifying event – expenses resulting from federally declared disasters– has been added to the safe harbor list of qualifying events.

What is the deadline for making plan changes based on the current proposed changes?

Employers can elect to rely on the proposed changes beginning this year prior to a formal plan amendment. However, the Treasury Department and the IRS expect that, if these regulations are finalized as proposed, plan sponsors will need to amend their plan’s hardship distribution provisions. As of this writing, the guidance is that most amendments will need to be made within the period ending the second year following the year that the rules have been finalized. (See section “Plan Amendments” in IRS Proposed Rule for details.)

In the interim, plan sponsors should consult their providers for guidance on implementation of these new proposed rules.

Concluding Thoughts for Plan Sponsors:

Hardship distribution provisions in 401(k) plans provide a valuable benefit to participants who may be experiencing temporary financial stress due to certain qualifying circumstances and to employers who may lose productivity from these employees. However, they put additional burdens on plan sponsors to properly understand the rules and have a process in place to implement their requirements. Best practices include proper documentation and retention for each request as well as full disclosure of the financial consequences to participants. Your plan providers should be consulted prior to giving specific guidance as they may require specific forms and disclosure documents that apply.

Plan sponsors electing to amend their plans to allow hardship withdrawals must do so during the current plan year and disclose the details of this change to participants by December 1 to have the changes take effect in the next plan year.

Brian C. Rall

President – Strategic Retirement Partners, LLC

Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education to company sponsored retirement plans.

Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.

Audit Proof Your Company’s 401(k) Plan!

It is highly probable that your company’s 401(k) plan will be subjected to audits conducted by the DOL and the Internal Revenue Service at some point in the future. If you are not 100% certain what documents you will need, download this free copy of our “Fiduciary Audit File Checklist” and be sure!