Rule expands penalty-free early 401(k) withdrawals — but new use ‘might not be practical,’ advisor says

Workers may have a new way to help prepare for a largely unpredictable health-related expense during their golden years.

Under a new rule now in effect, 401(k) plans are permitted to let participants take limited penalty-free withdrawals to pay for long-term care insurance, which covers the cost of assistance with daily living activities such as bathing, dressing and eating — and often is needed later in life. The new rule was included in 2022 retirement legislation known as Secure Act 2.0, and had a delayed effective date of three years, or Dec. 29.

However, it comes with limitations. Experts say it’s important to consider whether using retirement money to pay for long-term care insurance makes sense — or if you should purchase a policy at all.

“The [rule] is there for people, but it might not be practical to use it,” said Carolyn McClanahan, a physician and certified financial planner based in Jacksonville, Florida. She is a member of CNBC’s Financial Advisor Council.

Typically, withdrawals before age 59½ incur a 10% penalty, as well as ordinary taxes. There are already some exceptions when the penalty doesn’t apply, including for qualified birth or adoption, certain unreimbursed medical expenses and the so-called rule of 55, which applies if you leave your company in the year you turn age 55 or later.

If you reach your 65th birthday, you have about a 70% chance of needing some form of long-term care services and support, according to a 2020 estimate from the U.S. Department of Health & Human Services. On average, women who require care need it longer — 3.7 years, versus 2.2 years for men. While a third of 65-year-olds will never need long-term care, 20% will end up requiring it for more than five years.

However, Medicare — which is most people’s health coverage starting at age 65 — generally does not cover such care. While unpaid family members often serve as caregivers for stretches of time, more formal arrangements can become necessary — and those paid options can be expensive.

For example, the cost of a home health aide reached an annual median cost of $77,792 last year, up 3% from 2023, according to the 2024 Cost of Care survey conducted by Genworth Financial. The national annual median cost of a semi-private room in a nursing home rose to $111,325, up 7% from 2023. For a private room, the median yearly cost climbed 9% to $127,750. 

The options for covering these unpredictable costs range from self-insuring — you are wealthy enough to pay out of pocket when and if those expenses arise — to qualifying for Medicaid, which covers some forms of long-term care for individuals who have little to no financial resources.

For people in between the two extremes, some form of insurance is more common, said McClanahan, the founder of Life Planning Partners. However, she said, the claims process can be laborious for traditional long-term care policies, and the premiums for good coverage tend to be pricey.

For a pure long-term care policy, a 55-year-old male with $165,000 of coverage and a 3% yearly inflation protection — meaning the benefit grows by that amount yearly — would pay an average annual premium of $2,200, according to the American Association for Long-Term Care Insurance. For a policy with a 5% yearly benefit growth, the cost would be $3,710 annually. 

Women, who tend to live longer, face steeper pricing. A 55-year-old woman pays an average of $3,750 yearly for a $165,000 coverage and 3% yearly growth. For 5% benefit growth, the policy would cost $6,400 annually, according to the association.

Insurers can hike premiums from year to year.

Many people end up purchasing a hybrid policy, McClanahan said. This is typically a life insurance contract with a long-term care rider. In other words, there is some coverage for care costs, but there is also money passed on to a beneficiary if you don’t use any or all of the long-term care benefits.

In contrast, pure long-term care policies come with no guaranteed payout — if you die without having used any or all of the benefits of the insurance, the money you paid into it via premiums is effectively gone.

“The traditional policies cost a lot of money, and people don’t want to go into them because it goes away when you die,” McClanahan said. “The coverage with a hybrid policy is not as rich as a straight long-term care policy, but it’s still a bucket of money that can be accessed for long-term care.”