Need $1,000 to cover an unexpected expense? Starting this year, you might be able to withdraw money from your 401(k) relatively easily.
New rules make it easier to tap into retirement accounts for emergency funds. In 2024, you can withdraw up to $1,000 from a traditional 401(k) or IRA to cover emergency needs. And here’s a big change: You can now define what qualifies as an emergency.
More Americans are withdrawing funds from their retirement accounts in search of emergency cash. The share of savers who will withdraw funds from their retirement plans in hard times has doubled in three years, from 1.7% in 2020 to 3.6% in 2023, according to Vanguard’s Retirement Plan Analysis.
Traditional tax-free retirement accounts are designed to reward people who save for retirement and penalize those who withdraw funds early. You typically contribute pre-tax amounts to the account and pay taxes when you withdraw the funds.
Early withdrawals, usually before age 59 1/2, incur additional taxes equal to 10% of the amount, so if you’re paying a 15% tax rate and you withdraw early, you’re effectively losing 25% of your money before you’ve spent a cent.
There have long been exceptions to this rule: higher education expenses, the birth or adoption of a child, a first-time home buyer, the death or permanent disability of the account owner, etc. In such cases, you can usually withdraw your retirement funds and pay only ordinary income tax.
The new rules allow for “emergency” IRA withdrawals. How you define an emergency is up to you.
This year, a 2022 law known as Secure 2.0 changed the rules: You can now withdraw up to $1,000 to cover emergency personal expenses, which is defined as a scenario “to meet an unexpected or immediate financial need related to an urgent personal or family expense.”
The new language is fairly broad, covering not only certain categories but also “other necessary and emergency personal expenses.”
Consider the range of expenses that a reasonable person might consider to be unforeseen or imminent emergencies: car repairs, past-due utility bills, emergency dental work, a leaking roof, a parking ticket, making dinner, etc.
Retirement experts say the theory is that Americans should be able to withdraw money from their retirement accounts if they have an emergency need, and Congress tweaked the law to make those withdrawals simpler and faster.
“Being able to withdraw funds from a 401(k) for any kind of financial emergency should help make 401(k) plans a little more attractive,” said Jeff Clark, head of defined contribution research at Vanguard.
It’s tempting to think of your 401(k) as an ATM.
Cons: Under the new rules, it’s tempting to think of your 401(k) like an automated teller machine.
“Most people aren’t saving enough for retirement,” says Keith Singer, a certified financial planner in South Florida. “Helping people spend their retirement accounts early because of hardship will only lead to greater hardship, as they won’t have enough retirement assets to support themselves in the future.”
Policymakers want to encourage Americans to save for retirement. Social Security only covers a fraction of the costs retirees incur, and pensions are shrinking. In theory, the more you save in your retirement accounts, the better off you’ll be in retirement and the less of a strain on government-funded social services.
Tax benefits should make saving for retirement more attractive. But only about half of U.S. households have retirement accounts, according to the Federal Survey of Consumer Finances. Savings rates are especially low among low-income households. Many cash-strapped Americans feel they can’t afford to save for retirement or other goals.
And that’s the appeal of emergency withdrawals: In theory, knowing they can get their money back if something bad happens should make it easier to convince low-income Americans to open retirement accounts.
“Many households don’t have liquid savings. Many don’t have emergency funds. For many, their 401(k) plan is their only savings,” says Caleb Silver, editor-in-chief of Investopedia.
One solution to this problem is a Roth IRA. With a traditional retirement account, you pay taxes when you withdraw your money. With a Roth IRA, you pay taxes up front. Typically, you can withdraw your funds without taxes or penalties after you’ve invested for five years.
Economists say Roths are a good option for people with cash flow concerns because they provide a way to set aside money for emergencies. State governments give Roths preferential treatment with their automatic IRA programs, which automatically enroll employees of employers without retirement plans.
Under the new emergency withdrawal rules, traditional retirement accounts will become a bit more like Roth accounts, with at least some of your funds easily accessible.
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What are the rules for emergency retirement withdrawals?
Where:
You can only make one withdrawal per year You can’t withdraw more than $1,000 You can’t make emergency withdrawals that would put your account balance below $1,000 If you participate in a 401(k), your employer isn’t required to allow emergency withdrawals. Not all employers do.
To justify your resignation to your employer, you simply need to prove in writing that your situation “qualifies” as an emergency.
After you make an emergency withdrawal, you won’t be allowed to make another withdrawal for three years unless you pay back the amount or make new contributions to cover the balance. Paying back the withdrawn funds allows you to avoid paying income tax.
What is a hardship withdrawal?
Before this year, hardship withdrawals from 401(k) plans were permitted, allowing people to withdraw more than $1,000, but the rules were relatively strict.
To make a withdrawal during hardship, under the old rules, you must prove an “immediate and serious financial need,” such as funeral expenses, damage to your home, imminent eviction, etc. Typically, it’s up to your employer to determine whether an employee has an “immediate and serious” need, and the money can’t be repaid.
But hardship withdrawals cover a narrow range of categories.
“Let’s say your car breaks down. You need to get your car to work. That’s not a hardship[withdrawal]condition,” said Michael Shamrell, vice president of thought leadership at Fidelity Investments. “But it’s an emergency.”
New rules allow you to withdraw certain amounts from your retirement accounts in an emergency with a simplified procedure and more flexibility, but making an emergency withdrawal isn’t always a good idea.
When you withdraw from a retirement account early, “you reduce your balance and essentially minimize your future earnings,” Silver says. “You’re interrupting the compound interest that occurs within a 401(k), 403(b) or IRA. Compound interest is how money grows over time,” because it accrues interest as your account balance grows.
“You’re effectively robbing your future self,” Silver says.