401-K plans are a form of deferred-tax retirement account that allows for employees to divert a portion of their salary for retirement savings. Employers can match part of the contribution as a job benefit. None of the contributed funds or their investment gains are subject to taxes until they are withdrawn. 

That said, the rules over 401-K withdrawals generally state that they are subject to federal income tax, based upon the account holder’s tax bracket, with an additional 10% penalty if they are under the age of 59 ½.. However, new 2024 IRS guidelines under SECURE 2.0 are changing some of the rules regarding withdrawals, and they are important to know in order for retirees to take advantage of them in a strategically advantageous fashion.

Required Minimum Distributions (RMD)

RMDs for 401-K accounts are usually prompted by triggering events, which include:

• If the employee quits the job or officially retires;
• In the event the employee suffers a disabling injury or dies unexpectedly;
• The 59 ½ age minimum of the employee is reached. 
• The plan is officially terminated.
• The employee experiences a specific hardship as defined under the plan (more details below).

SECURE 2.0 eliminates the RMD rule for Roth 401-K plans as of 2024. RMD still applies to standard 401-K accounts.

Exceptions

There are a number of exceptions to the early withdrawal penalty rule and some modifications to 401-Ks under SECURE 2.0. The exceptions are categorized under “hardship exceptions” and can include:

• Medical bills for the employee, spouse, or dependents.
• Funeral expenses
• Home damage is caused by natural disasters or outside circumstances that are not under the employee’s control (like an out-of-control vehicle that rams into the property).
• College tuition and associated expenses for the employee, spouse or dependents.
• A terminal illness diagnosis.
• Employee suffers a disability.
• Giving birth or officially adopting a child.
• If called into active military duty.
• If payments were made to the employee’s beneficiaries upon the employee’s demise.
• The money was to pay for an IRS levy.
• If funds were moved into another retirement plan within 60 days.
• If an employee’s contributions were proven to be overestimated and the employee wants the correction differential.

In the case of hardship withdrawals, qualification criteria can vary between different employer plan policies regarding amount maximum restrictions, moratoriums on additional 401-K contributions, and income tax applicability.  Some specialized situation exceptions include:

• Personal Emergency Expenses: Although different employer plan administrators may have discretion for higher allowances, up to $1,000 can be withdrawn without penalty under SECURE 2.0 2024 for personal emergency expenses.  Income taxes would be due on the withdrawal, and the employee has a 3-year window to repay the distribution, or would be prohibited from further emergency withdrawals in that same period. Self-certification in writing to the employer that the withdrawal is for an emergency is the only prerequisite.

• SEPP (Substantially Equal Periodic Payments): SEPP is an IRS rule that allows for early withdrawals starting at age 54 ½, provided that the employee withdraws the exact same amount consecutively for every year until age 59 ½. Applicable income taxes are due for each withdrawal. 
• Rule of 55: The employee turns 55 or older and decides to leave the job (age 50 if working for federal firefighting, law enforcement, border protections, customs, or air traffic control). The Rule of 55 does have certain restrictions, i.e:
  • The Rule of 55 does not apply to traditional or Roth IRAs 
  • Money must remain in the employer’s plan until the employee turns 59 ½. 
  • Employers are not required to allow early withdrawals. 
  • The employer may require that the entire amount be taken out in a single lump sum. 

Domestic Abuse Victims: 

• Victims of domestic abuse under the age of 59 ½ can presently withdraw the lesser of up to $10,000, or 50% of a vested account balance, without triggering the 10% penalty.
• The victim can self-certify that abuse has occurred, and the victim distribution can be taken within a year of the specified domestic abuse incident. 
• Standard income taxes would be due upon withdrawal.
• If the abuse victim decides to repay the distribution within a 3-year period, eligibility for a refund of the taxes paid can be qualified.

Starting later on in 2025, 401-K plans under SECURE 2.0 may offer penalty-free withdrawals of up to $1,500 annually for long-term care insurance premium payments. SECURE 2.0 will also create a searchable database to help people track lost retirement benefits for which they may be entitled but found difficult to trace due to the employer going out of business or being acquired, multiple employment changes, and other circumstances. Millions of 401-K accounts have been shown to be routinely forgotten, and close to a trillion dollars in eligible retirement benefits currently go unclaimed. 

Tips and Warnings on Retirement Account Withdrawals

Retirement accounts are tax-deferred until withdrawals occur, so intelligently managing one’s finances when entering retirement is crucial to minimize taxes and maximize gains prior to withdrawal. With those principles in mind, below are some tips and warnings for new or pending retirees should bear in mind:

• Sequencing Withdrawals: When entering retirement, it’s wisest to tap other investments for income before the retirement accounts. The retirement funds should be allowed to continue to compound and generate gains until they are needed, or, ideally, until RMD after age 72-75 (depending on the plan and RMD guideline in effect) is triggered. The thinking behind this strategy is that by age 72, a retiree would be ostensibly in a much lower tax bracket than when just coming off peak earning age. 

• Roth 401-Ks Should Withdraw Last: Roth accounts have already prepaid taxes at conversion, so those should be allowed to generate the most pre-withdrawal gains. RMDs for Roth 401-Ks don’t apply. 

• Social Security: Delaying Social Security benefits until age 70 will entitle a retiree to maximum benefits. Any earlier age should be avoided, if possible since once benefits commence, the beneficiary rate is locked in. 
• Free Web Retirement Distribution Calculators: Many financial advice firms have free online web retirement distribution calculators. Developing the habit of using them to tweak a retirement withdrawal plan can help to save significant amounts by changing amounts, dates, and other criteria for optimum strategic advantage.
• Part-Time Business: If a hobby or pastime has the potential to be registered as a standalone business, starting one while still employed and then declaring it a full-time occupation during retirement can drastically lower one’s tax bracket, especially in years where net losses are generated. Expenses normally incurred as a hobby can be deducted against revenues as a business. As long as the business can generate a profit in 2 out of 5 years, the IRS will not declare the undertaking a hobby and continue to allow it to be categorized as a business. 

 

 

Thank you for reading! Have some feedback for us?
Contact the 24/7 Wall St. editorial team.