Failure to follow hardship rules
Top 10 retirement plan internal control pitfalls #6
Who has the responsibility for hardship distribution compliance, the record-keeper or payroll?
The record-keeper’s responsibility is to process the hardship distribution and to notify the plan sponsor. Once the plan sponsor is aware that the hardship distribution has been made from the plan, it’s up to the payroll department to suspend the deferrals for the six-month required period. This does not apply to all plans, but plans that use the IRS safe harbor methodology are required to do so. Yet sometimes the deferral is not suspended; this is an internal control issue.
As a solution, albeit an impractical one, the employee could be asked to return the amount of the hardship distribution; but this money may have already been spent on the hardship event. Alternatively, the improper elective deferrals (adjusted for earnings) could be returned to the employee—this may be the most practical choice and is, in fact, the solution most plans take. Or, the IRS offers the suggestion to suspend elective deferrals for a six-month period going forward, but this seems problematic as the employee may terminate employment.