401(k) Withdrawal Rules: Can You Access Your Funds Penalty-Free With A Terminal Illness?

Being diagnosed with a terminal illness will throw your life into chaos, and with that comes a host of financial concerns that can quickly eat up any savings you may have. Having access to your 401(k) can help ease the burden, but figuring out the rules for accessing those funds can be daunting. Ideally, you wait until retirement to start withdrawing funds from these accounts. Under normal circumstances, you can't take withdrawals before you reach 59 ½ years of age without paying a 10% penalty for what the IRS defines as an "early" or "premature" withdrawal. But in the case of Terminally Ill Individual Distributions, or TIIDs, you don't have to wait and can make withdrawals without having to pay the 10% tax penalty, as long as your plan allows for early withdrawals and you fulfill the requirements.

American Life Fund, an online resource that helps match terminally ill patients with financial resources, reports that the annual out-of-pocket costs of medical bills for individuals fighting cancer can exceed $12,000, and this number doesn't account for lost wages that result from being too sick to work. According to Forbes, the average American had $65,100 in personal savings in 2023, not counting retirement funds, an amount that can be quickly depleted in the event of a terminal illness. While there are ways to save money on health care bills, the cost of medical care makes having access to otherwise untouchable accounts, like retirement plans, invaluable.

Everyone should have an emergency fund to pay for unexpected things like medical expenses, but they should also focus on funding retirement accounts throughout their careers. One of the most common retirement plan options are 401(k) plans, which are designed to help you grow a retirement fund by contributing pre-tax income from your paycheck. Over time, combined with matching contributions from your employer (should they choose to participate in matching), that fund grows so you have a nest egg for when you retire. The SECURE 2.0 Act of 2022 was created to improve retirement saving opportunities, thus making it easier for U.S. workers to save for retirement with accounts like 401(k) plans. This law added special provisions to the original SECURE Act of 2019, working to encourage more Americans to save for retirement by improving the rules associated with such plans.

The Internal Revenue Code (IRC) Section 72(t) clarifies certain aspects of the law, including how those diagnosed with terminal illnesses can access their various retirement account funds, including 401(k) accounts. Under the SECURE 2.0 Act, those diagnosed with a terminal illness, one in which death is a realistic possibility within seven years, they are able to make withdrawals from their 401(k) without being assessed the 10% tax penalty that is generally required for individuals taking withdrawals prior to the age of 59 ½.

In order for a person with a terminal diagnosis to be eligible to take a TIID without paying the normal 10% penalty that comes with withdrawing from your 401(k) early, you need to provide a certification from a physician. This certification must include a dated physician's signature, a physical exam date, and an explanation of what led the physician to determine the illness is terminal. This certification must also note that death is a realistic result of the illness within seven years of the date of the certification. While no other supporting documents are needed, the certification must be provided to the administrator of the terminally ill individual's retirement plan administrator.

When it comes time to filing taxes, ideally your plan will allow for penalty-free TIIDs, in which case your employer will inform the IRS of the distribution. Although you aren't required to submit any documentation beyond the doctor's certification, by notifying the IRS of the distribution, your employer is acknowledging they have received your qualifying certification. If your plan does not allow for penalty-free TIIDs, you still have an option by way of an extra form you can submit with your taxes to qualify for the tax exemption. This form, known as Form 5329 (Additional Taxes on Qualified Plans (Including IRAs) and Other Tax Favored Accounts), would need to be completed by you or your tax preparer when filing in order to report your early withdrawal as a tax-exempt distribution