If you find yourself unemployed, it's natural to think about accessing 401(k) funds to make ends meet. Case in point: the coronavirus pandemic, which has left more than six million Americans without employment. Here's a recap on how 401(k) accounts work and the rules governing withdrawals, including new rules helping those impacted by the coronavirus pandemic.

Key Takeaways

  • A 401(k) plan helps workers save for retirement via contributions of pre-tax earnings.
  • New legislation allows withdrawals of up to $100,000 from 401(k) accounts without penalty for those affected impacted by the coronavirus pandemic.
  • Normally, hardship withdrawals from a 401(k) incur a 10% penalty. This could be avoided if 401(k) funds are rolled over into an IRA.
  • Workers 55 and older can access 401(k) funds without penalty if they are laid off, fired or quit.
  • Unemployed individuals can receive substantially equal periodic payments (SEPP) from a 401(k). These payments are distributed over a minimum of five years or until the individual reaches age 59½, whichever is greater.

How 401(k) Plans Work

A 401(k) plan allows employees to contribute pre-tax earnings toward retirement. Contributions are often invested in mutual funds or company stock and grow tax-free until retirement, when distributions are treated as taxable income. Normally, workers cannot access 401(k) funds until they are 59½. Early withdrawals are subject to a 10% penalty, in addition to being taxed as ordinary income.

401(k) Withdrawals During the Coronavirus Pandemic

Some plans allow for a 401(k) hardship withdrawal. These distributions can be taken due to an "immediate and heavy financial need." Individuals taking a hardship distribution may be subject to the 10% early withdrawal penalty, as well as taxes.

However, if your plan allows hardship withdrawals, the CARES Act signed into law by President Donald Trump temporarily suspends the 10% penalty for those impacted by the coronavirus. Individuals can withdraw up to $100,000 from a 401(k) or individual retirement account (IRA) without penalty. To qualify, the person or their spouse or dependent must be diagnosed with COVID-19. Or, the individual must have experienced financial hardship as a result of being quarantined, laid off, or furloughed; having work hours reduced; or being unable to work because of a lack of childcare. The distribution can be spread over three years, which gives impacted individuals three years to pay the taxes on the withdrawal as well as to replace the funds. In addition, the repayments would not be subject to annual retirement plan contribution limits.

How to Access Funds When You're Unemployed

Under ordinary circumstances, unemployment presents a series of choices for an individual who owns a 401(k). First, there's the question of whether to keep the account with the former employer or transfer the funds to a rollover IRA. If handled correctly, this transfer is not considered a taxable event.

Rolling over a 401(k) into an IRA might make it easier to access the funds. Under certain circumstances, IRAs are not subject to the 10% early withdrawal penalty (though you would need to pay taxes on the withdrawal). Some penalty-free IRA withdrawals include paying for unreimbursed medical expenses, health insurance premiums while you're unemployed, higher education expenses, or becoming permanently disabled.

Even if you didn't leave on the best of terms, read the rest of this article before deciding whether to roll over your 401(k) into an IRA.

The Age 55 Rule

If joblessness lingers, individuals face a second question: What happens if you haven't reached age 59½ and need to tap into your 401(k)? If you become unemployed in the calendar year when you turn 55 (or after that), you can access the funds without having to pay the 10% penalty. No need to wait until age 59½. In fact, if you have a 401(k) at another employer you left long ago, you can access those funds as well.

This is not true if you rolled over that money into an IRA. By the way, unlike with unemployment benefits, it doesn't matter if you were laid off, fired or resigned.

Substantially Equal Periodic Payments

What if you're under 55? There's another option for taking distributions without paying the 10% penalty. Unemployed individuals can receive what is termed a substantially equal periodic payment (SEPP) from their 401(k).

Payments must be distributed over a minimum of five years or until the individual reaches age 59½, whichever is greater. There are three different (and complicated) methods for calculating SEPP distributions: required minimum distribution (RMD), amortization and annuitization. Your choice can be modified once after an election if your income needs change. When the recipient reaches 59½, withdrawals may cease or ratcheted up or down without penalty. There are no further rules until you reach 72, when required minimum distributions take effect.

Payments are typically calculated based on the life expectancy of the account holder or the combined life expectancy of the plan participant and his beneficiaries. Distributions can be taken with any frequency during the year as long as withdrawals do not exceed the pre-calculated annual value. If the amount is arbitrarily modified, the 10% penalty exception is negated and you have to pay the penalties.

You can also withdraw money from an IRA using the SEPP method. An online calculator can help you estimate what to withdraw, but this is one task that requires the help of a financial advisor to make sure you do it correctly.

401(k) Hardship Withdrawals

Under IRS guidelines, 401(k) plans may allow for hardship withdrawals (if your employer permits it). Circumstances that qualify include medical expenses incurred by the employee, their spouse or dependents; the cost to purchase a principal residence; tuition or educational expenses; and payments necessary to avoid eviction from a principal residence. These distributions may be subject to the 10% early withdrawal penalty if taken before the age of 59½.

Hardship withdrawals are allowed only after other financial resources have been exhausted. This includes utilizing the assets of the worker's spouse and minor children.

Furthermore, the hardship distribution cannot exceed the amount of need, and the need should be documented. For example, if a worker is billed $5,000 for an inpatient hospital stay, the withdrawal cannot exceed that amount. However, the withdrawal may be increased to cover taxes and penalties.

Note, the CARES Act waives these rules for those affected by the coronavirus.

The Bottom Line

Obviously, tapping into retirement funds before you are retired isn't ideal, though sometimes it is unavoidable. Keep track of what you've spent. If you do find new work, try to repay what you withdrew into your new employer's 401(k). Also, consider making catch-up contributions. For 2020, those 50 and older can contribute an additional $6,500 to a 401(k), for a total contribution of $26,000. For IRA accounts, the catch-up contribution is $1,000, for a total of $7,000.

For help during this difficult time, unemployment insurance can be a stop-gap, and know what your options are when unemployment benefits run out.