Taking $1,000 from your 401(k) for emergencies is easier than ever - but consider these options first

By Jessica Hall

Tapping your 401(k) can be preferable to taking on high-interest debt, but here's what you need to know about how it works and what alternatives are out there

It's now easier to take $1,000 out of your retirement account for emergencies, but that doesn't mean you should.

Under the SECURE 2.0 legislation and a recent ruling by the IRS, you can withdraw $1,000 once a year from your retirement account for emergencies - defined as "meeting unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses."

While this gives people more options to battle emergencies, it's not one that should be taken lightly.

"It's nice to have the flexibility, more options, but it doesn't mean you should. Generally speaking, funds for retirement are meant for retirement," said Rob Williams, managing director of financial planning at Charles Schwab.

"Don't tap retirement funds for an emergency. It's almost good in your mind to say that money is untouchable. It's for your future self," Williams said. "Of course, we have emergencies and we have emotions. But the more you think about that money as earmarked for a special purpose, the better you'll be in the long term."

Troy Owens, a certified financial planner with AlphaCore Wealth Advisory, agreed.

"It's always typically the option of last resort," Owens said. "If you take sums out of your retirement accounts, you're significantly setting yourself back."

Previously, the only way to tap your retirement accounts were to take an early withdrawal and pay penalties and taxes; qualify for a hardship withdrawal for a dire emergency such as an eviction notice or funeral expense; or take a loan from a retirement account. The new legislation makes it easier to take funds, but there are guardrails on the amount allowed.

There's fine print to the new rules: you can't allow your total retirement balance to fall below $1,000. You have three years to put the money back into a retirement account or you'll pay income taxes on the withdrawal. You can only withdraw more funds if you've paid back the previous withdrawal. Also, your employer's retirement plan must allow emergency withdrawals.

Not all retirement plans may offer this option yet.

"This is still relatively new, so most employers are still considering if and how they'll add this feature to their retirement plans," said Cassandra Rupp, senior wealth adviser at Vanguard.

But if you don't tap your 401(k) for the emergency funds, where do you get the money to tackle an emergency? Consider this: more than a third of U.S. adults couldn't cover a hypothetical emergency expense of $400 using cash or its equivalent, like using a credit card they'd pay off in full the next month, according to the 2022 Economic Well-Being of US Households report released by the Federal Reserve.

Read: 'Emergency savings is the backbone of any good financial plan.' Saving for emergencies soon may be easier.

Owens said other options for emergencies might be better, such as taking funds from a Roth IRA where you can withdraw contributions made to a Roth penalty- and tax-free. (Earnings on those contributions, however, face restrictions.) Also, consider a 401(k) loan over a distribution, he said.

Of course, not everyone thinks tapping a retirement account is such a terrible idea when life's problems hit.

"With people feeling the pinch of inflation and costs remaining high, this definitely presents a unique opportunity. This is the IRS opening up more avenues," Ronnie Thompson, financial adviser and owner of True North Advisors.

"What's the alternative? With a credit card or a loan, interest rates are astronomically high and you could end up spending hundreds of dollars in interest," Thompson said. The $1,000 hit from your retirement fund is not such a huge number as to derail your future financial health."

"You should take this as an opportunity to look at why you are in the situation that you're in. What could you be doing differently?" Thompson said.

Thompson's recommendation is to create an emergency fund even before you invest in your future retirement. Automatic withdrawals from a checking account or paycheck into a high-yield savings account are relatively easy to set up and even small amounts add up. Schwab's Williams said ideally, people should have three months of expenses set aside for emergencies, but even a few thousand dollars can help cushion a crisis.

Once you've drained your emergency fund, try to do everything you can to replenish it, Williams said.

"Emergencies happen. Your car breaks down, you lose employment for a period of time. Something always comes up," Williams said.

-Jessica Hall

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09-07-24 0942ET

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