New 401(k) rule makes it easier to tap savings for emergencies

A new law has made it easier for Americans to tap their 401(k)s and other retirement accounts for emergencies as they continue to battle high inflation.

A new law will make it easier for Americans to use their 401(k)s and other retirement funds as an emergency ATM.

Under new IRS rules, Americans can now withdraw up to $1,000 from their 401(k)s without any penalties if the money is needed to cover a financial emergency. Acceptable reasons for a withdrawal include medical care, funeral expenses, auto repairs or "any other necessary emergency personal expenses."

In the past, individuals who made these types of withdrawals owed income tax on the money and could be hit with a 10% early withdrawal fee if they are under the age of 59½. The penalty could be waived if workers provide adequate evidence that the money is being used for a qualified hardship, such as a medical expense. 

A person who took a hardship withdrawal also could not pay it back to their 401(k), and was not allowed to roll that money into another retirement savings account. 

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But those rules were loosened earlier this year, when the SECURE Act 2.0 took effect.

Now, Americans will be able to withdraw from their 401(k) plans or IRAs for emergency expenses without those consequences. Savers are allowed to make one $1,000 distribution per year, and the funds must be repaid within three years. Savers will still need to pay income tax on the withdrawal if they don't pay it back, and they will not be able to make an additional hardship withdrawal.

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There are some exceptions. You cannot take out so much money that you leave your account balance below $1,000. And the emergency withdrawal is optional for employer plans, meaning that not everyone will be able to participate.

The change comes as a growing number of Americans tap their 401(k)s for emergency purposes amid stubbornly high inflation that has rapidly eroded workers' purchasing power.

Vanguard data shows that about 3.6% of workers participating in employer-sponsored 401(k) plans made a hardship withdrawal in 2023. That marks a major increase from the 2.8% rate recorded in 2022 and the pre-pandemic average of about 2%. It marks the highest level since Vanguard began tracking the data in 2004. 

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Workers are making more hardship withdrawals in part due to high inflation, which has forced most households to pay more for everyday necessities like food and rent. The burden is disproportionately borne by low-income Americans, whose already-stretched paychecks are heavily affected by price fluctuations.

As they spend more on everyday goods, Americans are burning through their savings and are increasingly turning to credit cards to cover those basic expenses.

Many financial experts, however, have cautioned savers to avoid making emergency withdrawals from their retirement accounts if they can help it. 

Taking money out risks savers losing out on the power of compound interest. Additionally, there are still tax drawbacks if that money is not returned within three years.