Between the rising cost of living and high interest rates, average Americans are strapped for cash, making it difficult to save for emergencies — or pay them off when they inevitably arise. But a recent change in tax law makes it easier than ever to tap into your retirement account for $1,000 in an emergency, penalty-free.
Typically, an early withdrawal from a tax-advantaged retirement account is not only taxed at the saver’s ordinary rate, but also faces a 10% penalty. Before this year, there were a limited number of circumstances — including birth or adoption and for first-time home buyers — in which someone could withdraw funds from their pre-tax retirement account before age 59 ½. (Savers can always withdraw contributions to a Roth IRA after taxes without penalty.)
These rules were relaxed this year. Since January, penalty-free withdrawals of up to $1,000 have been allowed for personal emergencies under the SECURE 2.0 Act, which made other significant changes to retirement plans. An emergency expenditure in this case is not defined by law; it can include funds to pay for “unforeseen or immediate financial needs related to necessary emergency personal or family expenses.” The law also created new exemptions for disaster relief, those with terminal illnesses and survivors of domestic abuse.
In the past, withdrawing money could have been a time-consuming task involving a lot of paperwork, but the new personal emergency rules speed up the process. Savers will still have to pay income tax on the withdrawal if they don’t take it back, since they contributed to a pretax 401(k) and traditional IRA. In the case of a 401(k), they must self-certify with their employer that the withdrawal is for an emergency.
The change comes as a growing number of Americans are making hard withdrawals from their retirement accounts. According to Vanguard, a record 3.6% of the 5 million accounts it manages saw an early withdrawal in 2023, up from 2.8% a year earlier.
There are a few catches: Not all employers have opted into the change, which means you may not be able to tap into your 401(k). It can be done at most once a year. And you can’t withdraw so much that you leave your account balance below $1,000.
You have three years to repay the money, although you don’t need to. That said, during those three years, no other emergency distributions can be taken out of the account unless the money is paid out or new contributions are made that are at least equal to the withdrawal.
Be careful with early withdrawals
While the change can be helpful for many people struggling to pay bills or facing an emergency — and it’s a better option than taking on credit card debt or taking out a payday loan — savers should avoid treating their retirement account like an ATM, to the best of their ability.
After all, retirement accounts are the largest portion of many families’ total savings. While $1,000 may not seem like a lot to spend now, it means losing an untold amount in future returns.
Additionally, not taking a distribution will also change a saver’s tax situation, which they should understand before going through with it. Most financial advisors agree that hardship withdrawals should be a last resort.
This story originally appeared on Fortune.com
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