Last year, a Federal Reserve survey saying that only 68% of Americans could cover a $400 emergency with cash made quite a stir. While an additional 21% said they could come up with the money somehow, their strategies often involved taking on debt. It's far from ideal, but up until now, low-income families haven't had many other options when faced with unplanned expenses.
That's set to change next year when a new SECURE 2.0 Act provision goes into effect. Here's what you need to know.
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Your retirement funds just got more versatile
Tapping your retirement account funds to cover emergency expenses has always been an option. It's your money, and no one can stop you from using it. But in the past, the government has strongly discouraged you from withdrawing your money early by charging a 10% early withdrawal penalty for funds taken out before you turn 59 1/2.
There are exceptions for things like paying costly medical bills or higher education expenses. But if you don't meet one of these specific criteria, you pay the penalty, plus income taxes if the money came from a tax-deferred account like a traditional 401(k) or IRA.
But the new rule change for 2024 will also enable you to take penalty-free withdrawals of up to $1,000 to cover emergency expenses. These distributions could only be used for "unforeseeable or immediate financial needs relating to personal or family emergency expenses." It doesn't give you a license to withdraw $1,000 to pay for anything you want.
In addition, you can only make an emergency withdrawal like this once per calendar year. You'll have up to three years to repay the distribution if you want. This is not required; however, you won't be able to make additional emergency withdrawals during that three-year period unless you pay back the first one.
It's worth noting that you'll still have to pay taxes on your withdrawals if the money comes from a tax-deferred account. However, it probably won't affect your tax bill significantly given the maximum emergency withdrawal is $1,000.
No penalty doesn't mean no consequences
Removing this penalty could be helpful to those in a financial bind who need money quickly and have no other way to get it. But it's important to recognize that making an early retirement account withdrawal still has long-term consequences.
You'll slow the growth of your savings and increase your tax bill today. You'll also have to save even more money for retirement going forward if you hope to retire on your original schedule. Or you may have to delay retirement to give yourself more time to save.
It's better to rely upon an emergency fund if you have one. If not, consider creating one now if you have extra cash on hand. Ideally, you want enough to cover at least three months of living expenses. Keep this cash in a high-yield savings account where you can access it easily.
But if this isn't possible or your emergency fund isn't enough, consider taking advantage of this new rule change in 2024 rather than taking on debt. Whenever possible, try to pay back your emergency withdrawals, both to help the growth of your savings and to enable you to make emergency withdrawals the following calendar year if you have to. And always remember to reevaluate your retirement plan if you have to take money out of your accounts earlier than anticipated.
