With the shift toward defined contribution plans, a significant portion of the average family’s assets other than their home may be locked up in a qualified retirement plan. In exchange for the powerful tax advantages, plan participants understand that there are barriers to raiding those assets prematurely.
Yet there are certain avenues by which one may access qualified retirement funds before retirement, subject to a host of rules promulgated by both the IRS and the employer, and the options vary by company. Tapping your 401(k) should be a last resort, but unanticipated emergencies do arise and sometimes retirement assets offer a viable alternative if done thoughtfully and correctly.
Fifty years ago, the predominant retirement vehicle was the traditional pension, if a worker had any retirement benefit at all. Known as defined benefit plans, they provided a retiree with a fixed monthly income for life based upon their earnings history. Employers bore the entire responsibility for funding and investing the assets to assure the payouts.
But a funny thing happened on the way to the gold watch. Since the 1950s, some employers had allowed bonuses paid out under profit sharing plans to be deferred rather than taken in cash, effectively delaying the taxation of the bonus. In 1978, Congress added a new subsection (k) to IRS code section 401 to formally protect these arrangements, adding certain restrictions on distributions before retirement. New regulations in 1981 allowed employees to make tax deferred contributions from their salary and employers to partially match those deferrals. Behold the birth of the 401(k).
Congress believed that the adoption of these new arrangements, referred to as defined contribution plans, would be relatively limited and that the lost tax revenue would be minimal. Au contraire. Today, among workers with retirement plans, 80% are defined contribution plans while traditional pensions represent just 20%, primarily in the public sector. Defined contribution plans including 401(k)s and 403(b)s hold $14 trillion in assets in the U.S. alone and represent the single largest tax expenditure in the entire budget, costing taxpayers $212 billion in lost revenue in 2024.
This compact with taxpayers is necessarily reciprocal. Retirement savers receive special dispensation by delaying taxation of their assets until retirement, allowing the balance to grow larger under the shelter of deferred liability to be taxed as distributed in retirement.
In exchange for the favor, retirement savers in these plans are subject to strict rules on when and how they may dip into the pot prematurely.
As a rule, distributions from qualified retirement plans like 401(k) and 403(b) plans as well as Individual Retirement Accounts are considered “early” if they are taken before age 59 ½. As such, they are subject to a 10% penalty in addition to federal and state income tax payable. IRA account holders may do so at their discretion, but this is not always true for company retirement plans.
The IRS code allows plan sponsors (employers) wide latitude to set the terms of eligibility, vesting, and withdrawals within the broad scope of the law, and early 401(k) distributions are only possible if the plan allows them. However, most plans make allowances for early withdrawals under some of the following circumstances. As the purpose of qualified retirement plans is saving for retirement, the rules governing early withdrawals are necessarily restrictive.
Hardship withdrawals. Plans may allow premature distributions to meet an “immediate and heavy financial need.” The distribution is limited to the amount of the actual need plus any income taxes due on the withdrawal.
Items that qualify include certain medical expenses, purchase of a principal residence, postsecondary tuition, funeral expenses for a family member, and repair costs due to casualty losses. Payments necessary to avoid eviction or foreclosure also qualify. An IRS bulletin wryly notes that purchase of a boat or television are generally not considered an immediate and heavy financial need.
Hardship withdrawals cannot be repaid and permanently reduce your long term retirement savings. They are also subject to the 10% early distribution penalty unless they qualify for a specific exemption as discussed below.
The SECURE 2.0 Act of 2022 added an additional provision for emergency expense distributions of up to $1,000 per year exempt from the 10% penalty. This distribution may be repaid through payroll deduction or direct contribution. Subsequent emergency withdrawals may only be made once the outstanding amount is repaid or after 3 years.
Exceptions to the early distribution penalty. There are a few situations in which the 10% penalty may be waived if the plan allows. Called qualified early withdrawals, these are different than hardship withdrawals, although some of the allowable reasons certainly constitute a hardship. For example, a participant may take up to $22,000 to recover from a federally declared natural disaster. Medical expenses more than 7.5% of adjusted gross income, permanent and total disability, and limited costs for adoption or birth of a child are exempt from the penalty. Federal and state taxes are still due, and the distributions cannot be repaid. Your plan administrator can provide more information.
401(k) loans. Rather than taking a distribution that cannot be re-contributed (and may incur a penalty), you might consider borrowing from your 401(k). If your plan allows, you can borrow the lesser of 50% of the vested balance or $50,000 to be repaid through payroll deduction over 5 years. The interest rate is typically set at the prime rate plus 1% to 2% which accrues back into your account.
A loan does not require a credit check and is neither taxable nor subject to the early withdrawal penalty. However, if you leave your job before completing repayment, the balance becomes due and payable. Failure to settle up promptly will result in a taxable distribution (except for Roth accounts) and the 10% penalty if you are under 59 ½.
Raiding your retirement stash should only be considered if all else fails, but in some dire circumstances it may be the only choice. Just be sure to understand the terms as well as the consequences.