Can I Contribute To a 401(k) While On Disability? Explore Retirement Savings Options

401(k)s and IRAs are the backbone of most working professional Americans' retirement plans. By contributing to these accounts while earning qualified income, you can withdraw funds after age 59 1/2 — ideally to supplement Social Security once you retire.

But what happens if you become disabled and unable to work while you’re still funding your retirement account? Can you still contribute to a 401(k)? The answer is, unfortunately, an emphatic no. 

The Internal Revenue Service (IRS) allows retirement plan contributions from compensation or “earned income” only. You can’t contribute to a 401(k) if you're not earning a paycheck. 

Luckily, some private disability insurance policies solve this retirement savings gap.

A quick overview: What is disability insurance?

Disability insurance has two primary categories: short-term and long-term. Since we’re talking about retirement in this article, long-term is the focus here. 

A long-term disability policy, also called an income protection policy, pays a monthly benefit amount if the policyholder suffers a covered disability. Also, the covered disability must last longer than the waiting period (also called the elimination period).

In most contracts, disability benefits are paid until age 65 if the individual never recovers from their disability. 

What happens when disability insurance runs out?

Here’s the catch — once the disability insurance policy expires and the monthly benefits stop, individuals could find themselves in an awkward situation. If they become disabled early in their careers and can’t accumulate significant retirement savings, they could become entirely dependent on the Social Security Administration (SSA) for income after retirement age. 

The risks of relying on Social Security for retirement income

Many Americans facing an unexpected disability turn to Social Security Disability Insurance (SSDI) as a solution. However, it should be viewed as a last resort rather than a primary safety net. 

Qualifying for SSDI is notoriously slow and difficult. The SSA requires that a disability affect your ability to work for at least a year, which can be financially devastating for most people. While receiving benefits, you may not perform any substantial gainful activity (SGA) for work (the definition of SGA varies depending on whether you’re self-employed). 

Additionally, you’ll likely need to have worked full-time for at least five out of the last 10 years to qualify for SSDI benefits unless you’re under 24.

Supplemental Security Income (SSI) may also be available, but it caps at less than $1,000 per month, which is insufficient for most people to live on. 

Can I withdraw from my 401(k) to survive through a disability?

Since Social Security disability benefits are usually inadequate to sustain the average person, withdrawing from a 401(k) might be their only option to remain financially solvent. However, withdrawing from a 401(k) or IRA before age 59 1/2 typically results in a 10% early tax penalty. 

Diminishing your individual retirement account through early distributions is a double whammy because you also end up paying taxes on funds that could have grown tax-free, such as in a Roth IRA. There are exceptions to the early withdrawal tax penalties for individuals who are permanently disabled. But again, you’d be at the mercy of the IRS.

Related: The Truth About Retirement Contributions: Debunking Common Misconceptions

How to protect your retirement income: Disability insurance options for a secure future

How can you protect your retirement income if SSDI isn’t the answer and early retirement account withdrawals can result in tax penalties? The solution is disability insurance with retirement protection.

Some insurers, like Guardian, MassMutual, and Principal, offer an optional retirement protection rider. It can be an add-on to a long-term disability policy or a separate policy, and the protection can solve the gap in financial planning for retirement. 

In the event a disability claim is approved, the company contributes monthly to a trust that mimics a 401(k) up to the annual contribution limit ($23,000 in 2024). This way, once the policy owner reaches full retirement age and the disability policy lapses, they can draw retirement benefits from the trust account. 

This rider can cover any monthly contributions an applicant or their employer makes when applying for their long-term disability policy. Like a 401(k), the insurance company gives the policyholder some control over the types of products the trust invests in.

Prioritizing insurance coverage: A strategic approach

Disability income protects the insured’s paycheck and, therefore, their lifestyle in the event of a disability. What about the scenario where that accident becomes life-endangering? That’s when life insurance can step in.

Life insurance doesn’t protect the insured — it protects their loved ones from financial hardships in the event of an untimely death. For instance, did they have an expensive mortgage with their spouse and the higher earning potential of the two? Do they have young children? 

If the insured passes away within the policy's covered term, their beneficiaries would receive a death benefit. The benefit usually comes as a lump sum or an annuity. 

Fortunately, term life insurance is relatively affordable compared to long-term disability insurance (it’s as if the insurance companies know we’re more likely to be disabled before age 50 than to die).

Here’s the order in which I would prioritize these benefit plans:

• Disability insurance. Our financial stability, both during and after our working career, will depend largely on how much income we earn. Making sure that this income is steady and guaranteed is a crucial piece of the puzzle. 
• Life insurance. Determine if there’d be any substantial financial harm caused by your unexpected passing and take steps to mitigate that risk. 
• Retirement accounts. 401(k)s and IRAs should come last in my opinion. While they’re no less important, retirement is possibly 30 to 40 years away for most of us. I’m not saying “YOLO,” but focusing only on the distant future can leave you woefully unprepared for the present.

Disability insurance with a retirement protection rider can be a valuable tool for safeguarding your income and retirement savings in the event of a disability. If you’d like to explore this option further, get a free, no-obligation quote using the form below. 

The experienced team at SLP Insurance can guide you through the process and answer any questions, ensuring you find the right coverage to protect your financial future.