401k, IRA: How to choose the best retirement plan for you
There are many different retirement plans available – traditional IRA, Roth IRA, 401k. Here’s how to choose the plan that will help you reach your goals.
Need $1,000 to cover unexpected expenses? Starting this year, you may be able to withdraw the money from your 401(k) account with relative ease.
New rules make it easier to tap your retirement account for emergencies. In 2024, you’ll be able to withdraw up to $1,000 from a traditional 401(k) or IRA account to meet an urgent need. And here’s a big change: You can define what counts as an emergency.
More and more Americans are raiding their retirement accounts to create emergency funds. The share of savers making emergency withdrawals from their retirement plans has doubled in three years, from 1.7% in 2020 to 3.6% in 2023, according to an analysis of plans by Vanguard.
Traditional tax-advantaged retirement accounts are designed to reward those who save for retirement and penalize those who withdraw the money early. You typically contribute tax-free money to the account and pay the tax when you withdraw the money.
If you withdraw early, usually before age 59½, you’ll incur an additional tax of 10% of the amount. If you pay a 15% tax rate and take an early withdrawal, you’ll effectively lose 25% of the money before you spend a dime.
There have long been exceptions to this rule. These include costs for higher education, birth or adoption, the purchase of a first home, and the death or permanent disability of the account holder. In such cases, you can usually withdraw your retirement savings and only have to pay normal income tax.
New rules allow “emergency” IRA withdrawals. They define the emergency.
The rules changed this year, thanks to 2022 legislation known as Secure 2.0. Now you can withdraw up to $1,000 to cover a personal emergency expense, a scenario defined as “meeting unforeseeable or immediate financial needs related to necessary personal or family emergency expenses.”
The new wording is quite broad and covers not only certain categories but also “all other necessary personal emergency expenses”.
Think about what expenses a reasonable person would consider an unforeseeable or immediate emergency: Car repairs. Overdue electric and gas bills. Urgent dentist visit. A leaky roof. A parking ticket. Getting dinner on the table.
Congress designed the law to make such withdrawals easier and faster, retirement experts say, based on the assumption that Americans should be able to access their retirement accounts in an emergency.
“The ability to withdraw money from a 401(k) plan for any type of financial emergency can help make 401(k) plans a little more attractive,” says Jeff Clark, director of defined contribution retirement research at Vanguard.
It’s tempting to think of your 401(k) as an ATM
The downside: Under the new rules, it’s tempting to think of your 401(k) plan as an ATM.
“Most people don’t save enough for retirement,” says Keith Singer, a certified financial planner in South Florida. “Helping them deplete their retirement accounts early because of an emergency will only create more difficulties later when they don’t have enough retirement assets to fund their lifestyle.”
Politicians want to encourage Americans to save for retirement. Social Security only covers part of the expenses that retirees face. Pensions are declining. The more money we save in retirement accounts, the theory goes, the better off we will be in retirement and the less of a burden we will place on government-funded social services.
Tax breaks are intended to make retirement savings more attractive. But according to the federal Consumer Finance Study, only about half of all American households have a retirement account. Savings rates are particularly low among low-income households. Many cash-strapped Americans do not believe they can afford to save for retirement or anything else.
That’s the appeal of emergency withdrawals. In theory, it should be easier to convince low-income Americans to open retirement accounts if they know they can reclaim the funds in an emergency.
“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) plan is their only savings,” said Caleb Silver, editor in chief of Investopedia.
One solution to this problem is the Roth IRA. With a traditional retirement account, you pay taxes when you withdraw the money. With a Roth, you pay the taxes up front. You can generally withdraw the money without taxes or penalties as long as you keep it invested for five years.
The Roth is a good option for anyone concerned about cash flow, economists say, because the money is there when you desperately need it. State governments are endorsing 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 traditional retirement account behaves more like a Roth account: At least some of the money is easily accessible.
Am I too old to open a Roth IRA? Don’t give up yet
What rules apply to emergency withdrawals from the retirement fund?
Here are the details:
- You can make one withdrawal per year.
- You cannot withdraw more than $1,000.
- You cannot make an emergency withdrawal that brings your account balance below $1,000.
- If you have a 401(k) plan, your employer is not required to allow emergency withdrawals. This is not the case with other employers.
To justify withdrawal to an employer, you simply need to confirm in writing that your situation “meets the requirements” of an emergency.
After you make an emergency withdrawal, you cannot make another one for three years unless you pay the money back or make new contributions to cover the balance. Paying back the funds you withdraw can help you avoid paying income tax.
What is 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 qualify for a hardship withdrawal, under the old rules, you must demonstrate an “immediate and severe financial need,” such as funeral expenses, damage to your home, or a threatened eviction. It is generally up to the employer’s discretion to determine whether the employee has an “immediate and severe” need and cannot repay the money.
However, hardship withdrawals only cover a narrow spectrum of categories.
“Let’s say your car breaks down. You have to get your car back to work. That’s not a hardship (withdrawal),” said Michael Shamrell, vice president of thought leadership at Fidelity Investments. “But that is an emergency.”
The new rules allow you to withdraw a limited amount from a retirement account in an emergency with less red tape and more flexibility. But that doesn’t mean an emergency withdrawal is always a good idea.
Every time you take an early withdrawal from a retirement account, “you’re reducing your balance and effectively minimizing your future earnings,” Silver said. “You’re interrupting the compounding that happens in a 401(k) or 403(b) or an IRA, and compounding is basically how you make your money over time,” since you’re earning interest on the rising account balance.
“You’re essentially robbing your future self,” Silver said.
