A 401(k) plan is a type of retirement savings account that allows people to save money for retirement while taking advantage of tax breaks. These programs, which are popular among American workers and businesses, are governed by regulations that the Internal Revenue Service (IRS) has the right to update. Recently, the IRS announced a substantial modification to the rules governing 401(k) plans and other retirement accounts.
Changes to the 401(k) governing rules
This new update focuses on the circumstances under which individuals may withdraw cash from their retirement accounts. According to the IRS, Americans will now be able to withdraw up to $1,000 from their 401(k) accounts without suffering a penalty, as long as the funds are utilized for unanticipated expenses. The IRS has recognized many instances in which such emergency withdrawals may be appropriate, including medical treatment, funeral expenses, car repairs, and other personal necessities.
Before this rule change, persons who attempted to withdraw cash from their 401(k) plans before the age of 59 and a half were required to pay income taxes on the amount removed. They also risked a 10% penalty for making an early withdrawal, which served as a strong barrier to individuals considering tapping their retirement resources prematurely. The new law, however, allows persons to escape these taxes and penalties provided they can establish that the withdrawal is essential to handle a true emergency; yet, if the withdrawal does not meet the criteria for an emergency, the 10% penalty applies.
It should be noted that this restriction only applies to cash withdrawals; transfers to another retirement account or returning monies to the 401(k) plan are not covered by this clause. The money must also be returned within three years to avoid penalties, and the account must always have a remaining balance of at least $1,000 for the withdrawal to occur. These improvements were facilitated by the SECURE 2.0 Act, which went into force in 2024.
To understand how this new rule fits into the larger architecture of 401(k) programs, consider how these plans work. A 401(k) plan is a qualified deferred compensation plan, which means that eligible employees can choose to contribute a portion of their income to the plan before taxes are withheld. This pre-tax contribution reduces the employee’s taxable income for the year, providing a tax incentive for retirement savings.
The IRS explains the tax implications of these contributions on its website: “Generally, your deferred compensation (commonly referred to as elective contributions) isn’t subject to income tax withholding at the time of deferral, and you don’t report it as wages on Form 1040, U.S. Individual Income Tax Return, or Form 1040-SR, U.S. Tax Return for Seniors because it isn’t included in box 1 wages on your Form W-2, Wage, and Tax Statement. However, it is included in wages subject to social security and Medicare withholding. Additionally, your employer must report the optional contributions as wages subject to federal unemployment taxes. Some plans additionally allow you to make your optional contributions after tax, as designated Roth contributions.”
Employees can also take cash from 401(k) plans in the event of an emergency or severe financial need. Historically, hardship distributions were limited to the amount of the employee’s elective contributions and excluded any gains from those contributions. However, since 2019, the scope of money accessible for hardship payments has been broadened, giving employees broader access to their savings during times of financial crisis. The IRS specifies that withdrawals made due to financial difficulty are not eligible for rollover to another retirement account, which is a critical feature that may not be well understood.