Obviously, qualified plans such as 401(k)s are meant to help individuals save for retirement in a tax-advantaged manner. But, under dire circumstances, you may have no choice except to tap into your nest egg early.

Doing so may result in additional income tax liability and penalties. However, the Setting Every Community Up for Retirement Enhancement (SECURE) 2.0 Act, which was signed into law in late 2022, provides not one, but two options if you find yourself in an emergency situation.

Background information: Employer-sponsored 401(k) plan

With an employer-sponsored 401(k) plan, participants can defer a percentage of their salaries to a separate account on a pretax basis, subject to annual limits. For 2023, you can sock away as much as $22,500. Even better, if you’re age 50 or older, you can kick in an extra “catch-up contribution” of $7,500, for a grand total of $30,000. SECURE 2.0 adds a special catch-up contribution for employees ages 60 to 63, but this provision won’t take effect until 2025. 

To top things off, an employer often adds “matching contributions” on behalf of employees up to a stated percentage of compensation. There’s no tax due on any of the contributions or earnings until withdrawals are made. That usually occurs in retirement when the participant may be in a lower tax bracket. 

Note that distributions from a 401(k) account are taxed at ordinary income rates currently reaching as high as 37%. Further, if you make a withdrawal before age 59½, you’re hit with a 10% penalty in addition to the regular tax, unless a special exception applies. 

Emergency expenses

SECURE 2.0 provides tax relief to 401(k) participants facing emergency expenses in two possible ways: 

1. Sidecar accounts. Beginning in 2024, employers may allow participants to withdraw funds from a special emergency savings account (ESA). Contributions to the accounts are made on an after-tax basis, meaning that there is no deduction allowed. The maximum annual amount allowed for this “sidecar account” is capped at $2,500 annually. Employees may be automatically enrolled at up to 3% of their compensation, subject to the $2,500 annual cap, though they can opt out.
   
   Participants can take up to one ESA withdrawal per month. Withdrawals are tax-free and penalty-free. Note that contributions to ESAs are eligible for matching contributions just like regular 401(k) deferrals. This means that if a participant is otherwise eligible for a matching contribution, the match won’t be lost simply because the participant is choosing to contribute to the ESA. However, any matching contributions must be made to the regular 401(k) account, not to the ESA.  
   
   
2. Unforeseen financial needs. Beginning in 2024, participants can make penalty-free 401(k) plan withdrawals — in addition to the amount of any eligible withdrawals from the ESA — of up to $1,000 per year for unforeseeable or immediate needs for personal or family emergencies. Note that withdrawals from a traditional 401(k) are not free of income tax. The employer can accept the employee’s written certification that such a need exists, but there’s a catch: If you make a withdrawal for this purpose, you may not make another “unforeseen financial need” withdrawal for three years, unless you’ve repaid the amount that was previously withdrawn. Keep in mind, also, that though these withdrawals are not subject to a penalty, they are, unlike the withdrawals from the sidecar account mentioned above, subject to any income tax that would otherwise apply. 

Get ready

If you participate in your employer’s qualified retirement plan, SECURE 2.0 provides the comfort of knowing that you’ll soon be able to access funds in an emergency without being penalized by the IRS. For more information about either option, contact your CPA.