The IRS has clarified a provision of the SECURE 2.0 Act passed in 2022, now expanding the use of tax-deferred retirement accounts as emergency funds. Previously, retirement savers with an “immediate and heavy” financial need could technically make an early withdrawal from their 401(k)s and traditional individual retirement accounts. However, that early withdrawal would be subject to income tax, and those under age 59½ typically owed a 10% tax penalty.
Now, you can make one withdrawal of $1,000 per year to cover personal and family emergency expenses without owing the 10% penalty. All you need to do is “self-certify” that you need the money for an emergency. Here’s what to know about how this new rule works, and what to keep in mind before you start using your 401(k) like an ATM.
How the new 401(k) emergency withdrawal rule works
Under the new guidelines, savers can withdraw up to $1,000 per year from their retirement plans for emergency expenses without facing the usual 10% early withdrawal penalty. This applies even if the account holder is younger than 59½, the standard age for penalty-free withdrawals. (Note: Victims of domestic abuse under the age of 59½ can withdraw up to $10,000 from IRAs and 401(k)s without owing the penalty.)
Key features of the new rule include:
No need to prove hardship: Unlike previous regulations, savers don’t need to demonstrate specific hardships to qualify for the withdrawal.
Flexible use: Funds can be used for various emergencies, from car repairs to medical bills, or even unspecified personal expenses.
Tax considerations: While the withdrawal is penalty-free, it’s still subject to income tax. However, if the funds are repaid within three years, no taxes are due.
Frequency limit: Only one emergency withdrawal of up to $1,000 can be made per year.
Account balance requirement: The retirement account must maintain a minimum balance of $1,000 after the withdrawal.
Understanding 401(k) withdrawals: Remember your long-term goals
One the one hand, this new rule provides much-needed flexibility for anyone facing financial challenges. Lower-income Americans may find it more appealing to open retirement accounts if they know those funds are at least somewhat accessible in an emergency. And for anyone truly strapped for cash, these penalty-free withdrawals could make a huge difference, and are far simpler to access compared to 401(k) loans.
On the other hand, the ability to self-define “emergency” may encourage unnecessary withdrawals, significantly impacting long-term retirement savings. Despite the newfound ease of access, remember why you have a 401(k) in the first place. While this new rule offers a safety net, these accounts are designed for long-term savings. Every dollar you take out prematurely is a dollar no longer growing for your future. The power of compound interest means that even small withdrawals can have a substantial impact on retirement savings over time. For instance, a $1,000 withdrawal at age 35 could potentially reduce your retirement balance by $8,000 or more by age 65 (assuming historical average market returns).
The bottom line
While the new 401(k) rule offers increased flexibility for savers, it’s essential to approach it with caution. Emergency funds should ideally come from other sources, such as dedicated savings accounts. Your 401(k) should remain focused on its primary purpose: securing your financial future in retirement.
Before making any withdrawals, consult with a financial advisor to understand the long-term implications and explore alternative options. Remember, the most effective retirement strategy is to contribute consistently and let your investments grow undisturbed over time.
