If you’ve had to dip into your retirement savings to cover immediate financial needs, you’re not alone. Recent data indicates a growing trend of individuals tapping into their 401(k)s and IRAs for financial emergencies. Vanguard Group recently reported a significant rise in early withdrawals, reaching an all-time high of 3.6% last year, up from 2.8% the previous year, based on around 5 million accounts.
Understanding the Impact of Early Withdrawals
Withdrawing from your retirement account prematurely typically incurs ordinary income tax and a penalty. However, there’s a silver lining. As of January 1 this year, the SECURE 2.0 Act has introduced new rules, allowing penalty-free withdrawals for personal emergencies and domestic violence.
Here’s what you need to know about how emergency retirement account withdrawals can affect your tax return.
IRS Rules on 401(k) Early Withdrawals
If you’re under 59½, withdrawing from your retirement account usually means paying regular federal income tax plus a 10% additional tax penalty. This has made early withdrawals less attractive for many in financial distress. However, a new provision starting in 2024 changes this scenario.
You can now make penalty-free annual withdrawals to cover personal emergency expenses. Specifically, you can withdraw up to $1,000 from your qualified plan (such as a 401(k), 403(b), 457(b)) or IRA once per calendar year without penalty. While you’ll still owe ordinary income taxes on the withdrawal, if you don’t repay the distribution within three years, you generally cannot take another personal expense distribution during that period. Self-certification to your employer that the withdrawal is for an emergency is required.
Defining an Emergency Expense
The IRS has clarified that an emergency personal expense distribution is meant to meet unforeseeable or immediate financial needs related to necessary personal or family emergency expenses. This can include medical expenses, car repairs, foreclosure prevention, or funeral costs.
Domestic Abuse Distributions under SECURE 2.0
The revised rules also offer tax relief to domestic abuse victims needing financial assistance. Suppose you are under 59½ and have experienced domestic abuse. In that case, you can withdraw up to $10,000 from a qualified retirement account (or 50% of your overall account balance, whichever is less) without the usual 10% penalty. Ordinary income taxes apply, but you can take this distribution within a year following a domestic abuse incident. Self-certification of the abuse is required, and repaying the distribution within three years can make you eligible for a refund of taxes paid on the repaid amount.
Taxes on 401(k) Withdrawals
When you withdraw from your retirement savings, the federal tax owed depends on several factors, including the type of account, your age, and your federal tax bracket. For instance, Roth 401(k) withdrawals are tax-free since contributions were made with after-tax dollars.
Under the new rules for domestic abuse and personal expense distributions, the ordinary income tax you typically pay won’t include the additional 10% penalty. However, be aware that your state may still tax retirement distributions.
Reporting Retirement Plan Distributions
Retirement plan distributions are reported on Form 1099-R, which you receive from your retirement plan. This form shows the amount withdrawn and the taxes withheld, and these amounts are reported on your federal income tax return.
