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How Americans can tap 401(k) type funds without a tax penalty, build up workplace savings

In Business
January 29, 2024

Congress has introduced dozens of provisions affecting workplace retirement plans, with the changes starting a couple years ago and continuing over the next few years. A few of the new rules that start in 2024 are tied, somewhat ironically, to saving for college and building up emergency savings.

Why ironic? Because those goals differ from retirement planning and could divert money from it. But by helping people get their other financial ducks in order and allowing them to tap into some retirement funds in a pinch, the new provisions could give reluctant savers the discipline to set aside retirement money for the long haul.

The new provisions stem from the retirement-focused Secure 2.0 Act, which was enacted in late 2022. Most are optional, in the sense that employers can choose to adopt or skip them.

One theme involves flexibility, in that many workers could gain easier access to some of their money prior to retirement age. It’s obviously best to let an account balance grow untouched for decades, but these provisions offer a safety valve for those who feel uncomfortable locking up their funds for so long. Otherwise, some of these people never will get started along the retirement-planning path.

“While this is retirement legislation, Congress has removed a number (of) barriers to saving for long-term goals,” said Kirsten Hunter Peterson, vice president of workplace thought leadership at Fidelity Investments.

A less-painful way to withdraw money

One new rule is fairly straightforward: Employees facing near-term financial needs can avoid the 10% penalty that normally applies on withdrawals from workplace 401(k)-type accounts, assuming their employers allow this.

Specifically, workers now may make one penalty-free withdrawal of up to $1,000 per year to meet unforeseen needs tied to “personal or family emergency expenses,” with the recipient self-certifying that he or she indeed faces an emergency. These withdrawals would avoid the 10% penalty, though the distributions still would be taxable.

The inability to pull out money, penalty free, for short-term needs has discouraged some workers from investing in 401(k) and similar plans, though many of these accounts do allow tax-free loans. With the new $1,000 withdrawal provision, workers would have the option of repaying the amount back into their accounts within three years, Peterson said. By contrast, 401(k) loans must be paid back or taxes and that 10% penalty await.

More help building up emergency savings

Another rule new for 2024 allows employers to offer emergency savings accounts tied to their 401(k)-style programs. In fact, employers can enroll workers automatically and take out up to 3% of their pay, or $2,500 annually, for this purpose. The money is treated as going in after tax, which means withdrawals won’t trigger taxes. This provision, for retirement plans that adopt it, isn’t available to highly compensated workers, as defined by the Internal Revenue Service.

The inability of so many Americans to build up emergency savings is a factor that likely discourages them from tying up money long-term for retirement. This provision should ease those concerns. This first four withdrawals in a year would be free of taxes and penalties, and employers could offer a match on those contributions.

However, more employers are starting to set up emergency savings programs not linked to 401(k) accounts. This route can provide more flexibility in addition to making the benefit available to all workers, regardless of income. Whether linked to a retirement plan or as a separate benefit, “There’s a ton of momentum around emergency savings in the workplace,” Peterson said. “Companies realize that their employees need help.”

Other Secure 2.0 changes

Another provision allows early withdrawals, on a penalty-free basis, in cases of domestic abuse. Up to $10,000 in penalty-free withdrawals is allowed for this purpose, or 50% of a worker’s vested account balance, whichever is less. Account holders would self-certify their status as abuse victims, according to an outline from Fidelity. The money can be paid back into the account within three years if the account holder chooses.

Like many other provisions, this one is optional in that employers can adopt or ignore it. Peterson said she doesn’t have a good feel yet as to whether this new rule will prove popular.

Also starting this year, employers can help their employees who are bogged down making student loan payments by providing matching funds on their behalf into retirement accounts. In other words, employers could treat workers’ loan payments as retirement contributions for the purpose of matching-fund eligibility. This one recognizes that while many workers will be struggling to pay off student loans, their retirement planning shouldn’t be entirely cut out.

“This allows an employer to contribute for retirement even when workers can’t make contributions on their own,” Peterson said.

Reach the writer at [email protected].

This article originally appeared on Arizona Republic: How Americans can tap 401 k style funds without a tax penalty

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