6 exceptions: How to avoid the 10 percent penalty on early retirement plan withdrawals
By Emily Roman
The beauty of a 401(k) account is their power to promise a comfortable, self-sufficient retirement. Still, emergencies happen, and money locked away for retirement is no help when someone faces surprise expenses for a broken-down car, funeral, or belongings lost to a natural disaster.
In many cases, anyone taking a withdrawal from a 401(k) before age 59½, generally considered an “early distribution,” pays the price via an additional 10 percent penalty excise tax. However, there are exceptions, and SECURE Act 2.0 created six new exceptions to avoid that 10 percent penalty.
These new, penalty-free early distributions – although, it’s important to note, not tax-free – can be claimed under these extraordinary circumstances:
Exception 1: Natural disaster: Hurricanes, wildfires, and other natural disasters occur more frequently and in regions once considered safe. Retroactive to January 2021, plan participants can withdraw up to $22,000 if they are in federally declared disaster areas and take their distributions within 180 days of the disaster. If repaid within three years, it’s considered a rollover distribution, allowing recovery of income tax paid.
Exception 2: Terminal illness: With a doctor’s certification of impending death within seven years, holders can withdraw any amount, with no maximum limit. Repayments made within three years allow recovery of the income tax paid.
Exception 3: Emergency expenses: This exception, effective in 2024, is broader than a hardship withdrawal. Allowable uses include auto repairs, medical care, funeral expenses, and preventing immediate eviction. Participants self-certify and can take distributions up to $1,000 per year as long as they pay them back. The penalty-free distribution can’t be taken for three years if not paid back. Employers do not have to write this provision in their plans, and in that case, employees can apply for tax relief in their 1040s.
Exception 4: Domestic abuse: Cases of domestic abuse include physical, psychological, sexual, emotional, or economic abuse. Eligible participants can withdraw a maximum of $10,000 or 50 percent of the account value, whichever is less. As with other exceptions, participants have a three-year window where they can, if they choose, repay the distribution and recover the income tax. Once again, employees can apply for tax relief on their 1040s, if the Plan did not adopt the provision.
Exception 5: Pension-linked emergency savings accounts: Despite its name, this exception is not linked to pension plans but to 401(k)s, 403(b)s, and 403(c)s. It’s like an emergency piggy bank with up to $2,500 available for short-term emergencies. This exception applies only to profit-sharing plan participants who are not highly compensated, defined as those not making more than $150,000, not among the top 20 percent of paid employees, or owners of 5 percent or more of the company.
Exception 6: Qualified long-term care distribution: This is for the lesser of $2,500 annually or 10 percent of the vested account balance. Participants must document the need with a long-term care premium statement that cites the policy owner, tax ID, premiums paid, and the name of the long-term care recipient.
Bottom line
In an age of uncertainties, the new exceptions written into SECURE Act 2.0 expand penalty-free access to retirement accounts – the funds that participants have worked for, and employers have contributed towards. Employers interested in learning more should contact their third-party providers or contact the Boyer & Ritter team for expert guidance on the advantages and peace of mind these provisions can deliver for employees.
Emily Roman, CPA, joined Boyer & Ritter in 2016 and brings extensive experience in performing and managing audits. As a generalist in reviews and audits, she works with a wide range of industries, including leasing and transportation. However, her primary expertise lies in construction and employee benefit plans. Contact Emily at 717-761-7210 or eroman@cpabr.com