If you find yourself unemployed, it’s natural to think about accessing 401(k) funds. Here’s how 401(k) accounts work and the rules governing withdrawals, including new rules to help those affected by the economic downturn and pandemic.
- 1 How 401(k) Plans Work
- 2 How to Access Funds When You’re Unemployed
- 3 age 55 rules
- 4 Sufficiently Equal Periodic Payments
- 5 401(k) Hardship Withdrawals
- 6 Bottom-line
- A 401(k) plan helps workers save for retirement through the contribution of pre-tax income.
- The new law allows withdrawals of up to $100,000 without penalty from 401(k) accounts for those affected by the coronavirus pandemic.
- Typically, hardship withdrawals from a 401(k) incur a 10% penalty. This can be avoided if the 401(k) funds are rolled over to an IRA.
- Employees age 55 and older can access 401(k) funds without penalty if they are fired, fired or left.
- Unemployed individuals can receive fairly equal periodic payments (SEPPs) from a 401(k). These payments are disbursed over a minimum of five years or until the individual reaches the age of 59, whichever is greater.
How 401(k) Plans Work
A 401(k) plan allows employees to contribute pre-tax income toward retirement. Contributions are often invested in mutual funds or company stock and grow tax-free until retirement, when distributions are treated as taxable income.
Generally, workers can’t access 401(k) funds until 59½. In addition to being taxed as ordinary income, early withdrawals are subject to a 10% penalty.
Some plans allow 401(k) hardship withdrawals. These distributions may be taken on account of “urgent and huge financial need”. Individuals taking hardship distributions may be subject to a 10% early withdrawal penalty as well as taxes.
How to Access Funds When You’re Unemployed
Under normal circumstances, unemployment presents a range of options for a person who owns a 401(k). First, there is the question of whether to keep the account with the former employer or transfer the funds to a rollover IRA. If handled properly, this transfer is not considered a taxable event.
Rolling a 401(k) into an IRA can make accessing the funds easier. In some circumstances, IRAs are not subject to the 10% early withdrawal penalty (though you will need to pay taxes on the withdrawal). Some penalty-free IRA withdrawals include paying unreimbursed medical expenses, health insurance premiums while unemployed, higher education expenses, or being permanently disabled.
Even if you haven’t left on the best of terms, read the rest of this article before deciding whether to roll over your 401(k) to an IRA.
age 55 rules
If unemployment persists, individuals face a second question: What if you haven’t reached age 59 and need to tap into your 401(k)? If you become unemployed within a calendar year of age 55 (or later), you can access the funds without paying the 10% penalty. No need to wait until age 59. In fact, if you have a 401(k) at another employer that you left long ago, you can access those funds as well.
This is not true if you rolled that money into an IRA. Well, unlike unemployment benefits, it doesn’t matter if you were fired, fired, or resigned.
Sufficiently Equal Periodic Payments
What if you are under 55? There is another option to take distributions without paying the 10% penalty. Unemployed individuals can receive substantial equal periodic payments (SEPPs) from their 401(k).
Payments must be disbursed over a minimum of five years or until the individual reaches age 59, whichever is greater. There are three different (and complex) methods for computing the SEPP distribution:
- Required Minimum Distribution (RMD)
If your income needs to be changed, your choice can be modified once after the election. When the payee reaches 59½, the withdrawal may stop or be ratcheted up or down without penalty. While the required minimum distributions are in effect, there are no further rules until you reach 72.
The payout is generally calculated based on the life expectancy of the account holder or the combined life expectancy of the plan participant and his or her beneficiaries. Distributions can be taken at any frequency during the year as long as the withdrawal does not exceed the pre-calculated annual value. If the amount is modified arbitrarily, the 10% penalty exception is negated and you will have to pay the penalty.
You can also withdraw money from an IRA using the SEPP method. An online calculator can help you estimate what to withdraw, but it’s a task that requires the help of a financial advisor to make sure you do it correctly.
401(k) Hardship Withdrawals
Under IRS guidelines, 401(k) plans may allow hardship withdrawals (if your employer allows it). Eligible circumstances include:
These distributions may be subject to a 10% early withdrawal penalty if taken before age 59.
Hardship withdrawals are allowed only after other financial resources have been exhausted. This includes using the property of the worker’s spouse and minor children.
In addition, the difficulty distribution cannot exceed the amount of the requirement, and the need must be documented. For example, if an employee is billed $5,000 for a hospitalization, the withdrawal cannot exceed that amount. However, withdrawals can be increased to cover taxes and penalties.
Obviously, tapping into retirement funds before you retire is not ideal, although sometimes it is unavoidable. Keep track of what you have spent. If you get a new job, try to pay back what you withdrew into your new employer’s 401(k).
Also, consider making a catch-up contribution. For 2021 and 2022, people 50 and older can contribute an additional $6,500 to a 401(k). For IRA accounts, the catch-up contribution is $1,000, for a total of $7,000.
For help during this difficult time, unemployment insurance can be a stop-gap, and learn what options you have when unemployment benefits run out.