IRS Announces Significant Rule Change for 401(k) Accounts – What This Means for Your Retirement

MJP –

A 401(k) plan is a retirement savings account that allows individuals to set aside funds for their retirement while benefiting from certain tax advantages. These plans, popular among U.S. workers and employers, are governed by regulations that the Internal Revenue Service (IRS) has the authority to update and recently, the IRS announced a significant change to the rules governing 401(k) plans and other retirement accounts.

Changes in the 401(K) governing rules

This recent update specifically addresses the circumstances under which individuals can withdraw funds from their retirement accounts. According to the IRS, Americans will now have the option to withdraw up to $1,000 from their 401(k) accounts through an ATM without incurring a penalty, provided the withdrawal is used to cover unexpected expenses.

The IRS has identified several scenarios where such emergency withdrawals may be applicable, including costs associated with medical care, funeral arrangements, car repairs, and other personal emergencies.

Before this rule change, individuals who sought to withdraw funds from their 401(k) accounts before reaching the age of 59 and a half were subject to income taxes on the amount withdrawn. Additionally, they faced a 10% penalty for making an early withdrawal, which served as a significant deterrent for those considering accessing their retirement savings prematurely.

SEE MORE –

Prepare for SNAP Changes: Food Stamps Increase Details and Updates Before 2025

The new rule, however, allows individuals to avoid these taxes and penalties if they can demonstrate that the withdrawal is necessary to address a legitimate emergency but if the withdrawal does not meet the criteria for an emergency, the 10% penalty will still apply.

It is important to note that this rule applies exclusively to cash withdrawals; transfers to another retirement account or returning the funds to the 401(k) plan are not covered by this provision. The money will also need to be returned within three years to escape penalties and the account must always have a remaining balance of at least 1,000$ for the withdrawal to happen. These changes were facilitated by the SECURE 2.0 Act, which came into effect in 2024

To understand how this new rule fits into the broader framework of 401(k) plans, it is helpful to review how these plans function. A 401(k) plan is a qualified deferred compensation plan, meaning that eligible employees can elect to have a portion of their income contributed to the plan before taxes are withheld. This pre-tax contribution reduces the employee’s taxable income for the year, offering a tax benefit that encourages 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’s included as wages subject to withholding for Social Security and Medicare taxes. In addition, your employer must report the elective contributions as wages subject to federal unemployment taxes. Some plans also allow you to elect to make your elective contributions on an after-tax basis as designated Roth contributions.”

401(k) plans also offer the option for employees to withdraw funds in cases of immediate and severe financial need. Historically, these hardship distributions were limited to the amount of the employee’s elective contributions and did not include any earnings on those contributions.

However, since 2019, the scope of funds available for hardship distributions has been expanded, allowing employees greater access to their savings in times of financial distress. The IRS clarifies that distributions made due to financial hardship are not treated as eligible for rollover to another retirement account, which is an important detail that may not be widely known.