The in-service distribution rules for 401(k) plans are complex and restrictive. They are designed to restrict employees from withdrawing their savings pre-retirement unless unique circumstances exist. SECURE 2.0 added several new in-service distribution options. Employers should understand their documentation, taxation, and repayment requirements to decide whether adopting one or more of the new options is worth the additional administration.
Some of the new in-service distribution options are available now, while others are available in the future. They apply to disasters, terminal illnesses, emergencies, domestic abuse, emergency savings, and long-term care premiums. Here’s what you need to know.
SECURE 2.0 In-Service Distribution Options
The most important thing to know about these new in-service distribution options is that they are optional. A small business is not required to add any of these options to its 401(k) plan. All of the new SECURE 2.0 options share three common features:
- Although taxable income, the options are exempt from the 10% penalty tax for early distributions from a 401(k) plan.
- No 20% mandatory withholding on the distribution amount, but employees may specify withholding if desired.
- Ability to re-pay the distribution amount back to the 401(k) plan within three years.
Below is a summary of the rules for each new in-service distribution option. Consider the potential benefits for your employees. Your provider should also be able to assist you in evaluating or electing these options.
A distribution up to $22,000 may be available for “affected employees” of federally declared disasters. An “affected employee” has his or her principal residence located in the disaster area and has sustained an economic loss due to the disaster.
An employee may also elect, but is not required, to have the distribution taxed ratably over three years. For example, an employee takes a $21,000 disaster distribution in 2023. That employee may report $7,000 as taxable income in 2023, 2024 and 2025.
Although distributions have been allowed for specific federally declared major disasters in the past (up to $100,000), SECURE 2.0 makes these distributions available (up to $22,000) for any federally declared major disaster.
Distributions for Terminal Illness
A distribution in connection with a terminal illness is exempt from the 10% penalty tax for early distributions. Terminal illness means you have been certified by a physician as having an illness or physical condition which can reasonably be expected to result in death in 84 months or less.
Unlike the other SECURE 2.0 in-service distribution options, employees cannot take a distribution from a 401(k) plan solely for a terminal illness. A separate distributable event, such as termination of employment, must be the trigger for the distribution. If a terminally ill employee takes a distribution based on his or her termination of employment, then the distribution would be exempt from any potential penalty tax for early distribution.
Beginning in 2024, one distribution up to $1,000 per year may be available for emergency purposes. Employees may self-certify that they meet the requirements for a distribution based on an "emergency". An "emergency" is defined as having an unforeseeable or immediate financial need relating to necessary personal or family emergency expenses.
An employee is unable to receive another distribution for emergency purposes until:
- The previous distribution is fully re-paid to the 401(k) plan;
- Contributions at least equal to the previous distribution are made to the 401(k) plan; or
- Three years have passed since the previous distribution.
Distributions for Domestic Abuse Victims
Beginning in 2024, distributions may be available to domestic abuse victims. The maximum amount is the lesser of: (i) $10,000 (indexed for inflation); or (ii) 50% of the employee’s vested account balance. Distributions would be available during the one-year period beginning when the employee is a victim. Employees may self-certify that they meet the requirements for a distribution based on domestic abuse.
Distributions of Emergency Savings
Beginning in 2024, 401(k) plans may include an emergency savings account (ESA) for non-highly compensated employees (NHCEs). This separate ESA is only funded with Roth contributions. The account (not contributions) is capped at $2,500 (indexed for inflation), but the employer may specify a lower amount.
NHCEs may take distributions up to $2,500 (indexed for inflation). They must be allowed to take at least one distribution per month, and the first four distributions per year cannot be subject to fees. Due to the ESA being a Roth account, distributions will be considered qualified (earnings excluded from taxable income) regardless of age or contribution timing.
Distributions for Long-Term Care Premiums
Beginning after December 28, 2025, distributions may be available to pay for premiums of qualified long-term care insurance for an employee or spouse. The maximum annual amount is the lesser of: (i) amount paid or assessed for the insurance; (ii) 10% of the employee’s vested account balance; or (iii) $2,500 (indexed for inflation). The employee must provide a long-term care premium statement to the employer to receive the distribution.
Evaluating In-Service Distribution Options
In-service distributions from a 401(k) plan can be a financial lifeline when employees have nowhere else to turn. Employees may even contribute more to the plan with the peace of mind that a distribution is possible in special circumstances.
On the other hand, in-service distribution options increase the administrative burden. These options have additional layers of documentation, taxation, and reporting requirements that can lead to costly mistakes if not done properly.
Small businesses should weigh the benefit to the employees against the additional burden and cost in determining if their 401(k) plan should offer in-service distributions, including the new options created in SECURE 2.0.