Accessing 401(k) Assets Early: Know the Options—and the Potential Hurdles
By Jonathan Yahn, JD, CPC
Over the past 40 years, 401(k) plans have supplanted traditional defined benefit pension plans as the retirement plan that Americans are most familiar with. But while 401(k) plans are popular for retirement savings, federal rules restrict withdrawals from these plans even more than they do for IRAs. Even so, it may be worth discussing how to gain early access to plan assets, especially with clients who may be dealing with financial repercussions of the coronavirus (COVID-19) pandemic.
Please see the companion article in this issue of The Link, which addresses taking early distributions from IRAs.
Pretax Employee Deferrals
The salary deferral feature in a 401(k) plan provides the single greatest benefit for most savers. But current law prevents plans from paying out deferrals before age 59½, with some exceptions. For example, a plan may be designed to allow for distributions when certain “hardship” events arise. Current regulations provide for the following “safe harbor” distribution reasons. These safe harbor reasons make it easier to meet the requirements for receiving a hardship distribution.
Medical care – care for the plan participant, a spouse, dependents, or a primary beneficiary that would qualify for a deduction on an individual’s federal income tax return
Principal residence – to purchase a participant’s principal residence
Tuition and related educational expenses – includes post-secondary expenses for the plan participant, a spouse, dependents, or a primary beneficiary for up to 12 months beyond the date of distribution
Preventing foreclosure or eviction – includes the amount needed to prevent the participant’s eviction from his or her primary residence or the foreclosure on the mortgage for that residence
Funeral expenses – for the participant’s parents, spouse, children, dependents, or a primary beneficiary
Casualty repair – to repair damage to a participant’s principal residence that would qualify for a casualty deduction (even if below the 10 percent threshold).
Federal disaster declarations – for certain expenses and losses, including the loss of income, as a result of a federally-declared disaster
While these withdrawals could provide critically important help in fairly narrow circumstances, they are not available for most ordinary emergencies, such as a car repair or appliance replacement. Further, hardship distributions are still subject to a 10 percent penalty tax—in addition to ordinary taxation—if the participant is under age 59½. So participants that use this hardship withdrawal option may pay a steep price for tapping into their 401(k) deferrals.
Roth Employee Deferrals
Like pretax deferrals, Roth 401(k) deferrals are subject to strict withdrawal rules. Roth assets, however, offer a big advantage: when they are paid out, the plan participant is not taxed on the deferral portion. But unlike Roth IRA distributions, Roth 401(k) deferrals must include a proportionate amount of earnings in the Roth account, which—depending on facts and circumstances—could be taxable and subject to penalty. So it’s not as simple as requesting a return of the contributions. Instead, the plan administrator must calculate the earnings portion of each withdrawal, which may lead some employers to restrict Roth deferral distributions. If hardship distributions of Roth deferrals are allowed, they may be a good source for addressing a COVID-19-related shortfall.
Employee After-Tax Contributions
Distributions of employee after-tax (basis) contributions might be the best way for 401(k) plan participants to meet a pressing financial need. Plan provisions generally permit withdrawals from such accounts at any time. But there are still roadblocks.
Most 401(k) plans do not currently permit after-tax contributions. (Keep in mind that after-tax and Roth contributions are different provisions entirely.)
Distributions must still be calculated to proportionately pay out both basis and earnings, and earnings are taxable and may be subject to the 10 percent penalty tax.
Even if a 401(k) plan does allow after-tax contributions, for those rank-and-file workers who might most need to take an early distribution—workers with modest incomes—Roth and pretax deferrals probably make more “tax sense” than after-tax contributions. So it is quite likely that these workers simply do not have any after-tax contributions to pull from.
Employer Matching and Profit-Sharing Contributions
Federal rules allow employer contributions to be distributed more liberally than employee deferrals. For example, a plan could provide for distributions of employer contributions after the employee has been a participant for five years. But this is rare. More frequently, employers choose plan provisions for their matching and profit sharing contributions that mirror the restrictions for employee deferrals. This makes plan administration much easier. And even if the employer permits earlier access to this source of plan assets—most likely by allowing hardship distributions that follow the rules discussed above—the assets are subject to taxation and likely a 10 percent penalty tax.
Plan Loans
Many employers permit plan participants to borrow money from their 401(k) plans based on the account balance. Detailed requirements apply, but the basic loan amount is the lesser of one-half of the participant’s vested balance or $50,000. This can be a fairly attractive way to deal with an immediate financial need, especially when a participant justifies the loan with the rationale that, “Hey, I’m paying myself back, with interest!” Unfortunately, it isn’t unusual for a participant to use a plan loan to escape a pressing cash crunch, only to begin a downward financial spiral caused by additional loan payments. Plan loans can provide an economic lifeline, but plan participants should carefully count the cost before signing a promissory note.
Several rounds of COVID-19 relief legislation may have helped some Americans, but many, nonetheless, are facing perilous financial times. And in these situations, some workers may seek to take whatever relief their employer plan may offer. Of course, participants should check with their employers to see whether their plans allow for loans or distributions before age 59½ and, if so, what rules apply. But as with IRA distributions, taxes and penalties may create a trap for the unwary. Those who are tempted to take early retirement plan distributions or loans should carefully consider all of their alternatives.
