Charles Langston:Can I use my 401(k) as an ATM? New rules allow emergency withdrawals.

Need $1,Charles Langston000 to cover an unexpected expense? Starting this year, you may be able to withdraw the money from your 401(k) with relative ease.

New rules make it easier to tap your retirement account for emergency funds. In 2024, you can cash out as much as $1,000 from a traditional 401(k) or IRA to cover an urgent need. And here’s a big change: You get to define what counts as an emergency.

More American are raiding retirement accounts for emergency cash. The share of savers making hardship withdrawals from retirement plans has doubled in three years, from 1.7% in 2020 to 3.6% in 2023, according to a Vanguard analysis of its plans.

Traditional tax-sheltered retirement accounts are designed to reward those who save for retirement, and to penalize those who withdraw the money early. You generally contribute pre-tax dollars to the account and pay the tax when you take the money out.

Early withdrawal, typically before age 59 ½, triggers an additional tax equal to 10% of the sum. If you are paying a 15% tax rate and make an early withdrawal, you effectively lose 25% of the money before you spend a dime.

There have long been exceptions to that rule. They include higher-education expenses, birth or adoption, a first-time home purchase, and the death or permanent disability of the account owner. In such cases, you can generally withdraw retirement funds and pay only ordinary income tax.

New rules allow 'emergency' IRA withdrawals. You define the emergency.

The rules changed this year, courtesy of the 2022 legislation known as Secure 2.0. Now, you can withdraw up to $1,000 to cover an emergency personal expense, a scenario defined as “meeting unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses.”

The new language is pretty broad, covering not just specific categories, but also “any other necessary emergency personal expenses.”

Consider the range of expenses that a reasonable person might deem an unforeseeable or immediate emergency: Car repairs. Delinquent utility bills. Urgent dental needs. A roof leak. A parking ticket. Putting dinner on the table.

Congress tailored the law to make such withdrawals simpler and faster, retirement experts say, on the theory that Americans should be able to tap their retirement accounts for an urgent need.

“The ability to draw money out of a 401(k) for any type of financial emergency, it can help make 401(k) plans a little bit more attractive,” said Jeff Clark, head of defined contribution research at Vanguard.

It's tempting to think of your 401(k) as an ATM

The downside: It’s tempting, under the new rules, to think of your 401(k) as a cash machine.

“Most people aren’t saving enough for retirement,” said Keith Singer, a certified financial planner in South Florida. “Helping them consume their retirement accounts early because of a hardship will only create a bigger hardship down the road, when they don’t have enough retirement assets to support their lifestyle.” 

Policymakers want to encourage Americans to save for retirement. Social Security covers only some of the expenses retirees face. Pensions are in decline. The more money we sock away in retirement accounts, the theory goes, the more we will thrive in retirement, and the less we will strain government-funded social services.

Tax breaks are supposed to make retirement savings more attractive. Yet, only about half of American households have retirement accounts, according to the federal Survey of Consumer Finances. Savings rates are particularly low among low-income households. Many cash-strapped Americans don’t feel they can afford to save, for retirement or anything else.

Therein lies the appeal of the emergency withdrawal. In theory, it should be easier to convince lower-income Americans to open retirement accounts if they know they can reclaim the funds in a pinch.

“There are many households that don’t have liquid savings. There are many households that don’t have emergency funds. For many households, the 401(k) is their only savings,” said Caleb Silver, editor-in-chief of Investopedia.

One solution to that problem is the Roth IRA. In a traditional retirement account, you pay taxes when you withdraw the money. With a Roth, you pay taxes upfront. You can generally withdraw the funds without taxes or penalties, as long as you had them invested for five years.

The Roth is a good option for anyone concerned about cash flow, economists say, because the money is there if you urgently need it. State governments favor the Roth in their auto-IRA initiatives, which automatically enroll workers whose employers don’t have retirement plans.

Under the new emergency-withdrawal rules, a conventional retirement account behaves a bit more like a Roth: Some of the money, at least, sits within easy reach.

Am I too old to open a Roth IRA?Don't count yourself out just yet

What are the rules for emergency retirement-fund withdrawals?

Here are the details:

• You can make one withdrawal per year.
• You can’t take out more than $1,000.
• You can’t make an emergency withdrawal that brings your account balance below $1,000.
• If you have a 401(k), your employer doesn’t have to allow emergency withdrawals. Not all do.

To justify the withdrawal to an employer, you need only certify in writing that your situation “satisfies the conditions” for an emergency.

After you make an emergency withdrawal, you aren’t allowed to make another one for three years, unless you either repay the money or make new contributions to cover the balance. If you repay the withdrawn funds, you can avoid paying income tax.

What's a hardship withdrawal?

Before this year, hardship withdrawals from 401(k) plans were allowed, and you could cash out more than $1,000, but the rules were comparatively strict.

To make a hardship withdrawal, under the older rules, you must demonstrate an “immediate and heavy financial need,” such as funeral expenses, damage to your home or an imminent eviction. It’s generally up to an employer to determine whether the worker has an “immediate and heavy” need, and you can’t pay the money back.

But hardship withdrawals cover a narrow range of categories.

"Let's say your car breaks down. You need to get your car to work. Now, that doesn't qualify for a hardship [withdrawal]," said Michael Shamrell, vice president of thought leadership at Fidelity Investments. "But that's an emergency."

Under the new rules, you can withdraw a limited sum from a retirement account for an emergency with less red tape and more flexibility. That does not, however, mean that an emergency withdrawal is always a good idea.

Any time you make an early withdrawal from a retirement account, “you’re reducing your balance, and you’re effectively minimizing your future returns,” Silver said. “You’re interrupting the compounding that happens inside a 401(k) or a 403(b) or an IRA, and compounding is really how you make your money over time,” as you earn interest on the rising balance of your account.

“You’re effectively robbing your future self,” Silver said.