More Americans are withdrawing money from their 401(k) retirement plans to forestall evictions and cope with other financial emergencies, a move that threatens their financial well being in retirement.
“The increasing use of retirement savings for other purposes is particularly troubling given that the responsibility of saving for retirement has shifted away from employers to individual employees,” said Federal Reserve Governor Elizabeth Duke, speaking in late May at a conference on co-sponsored by the reserve’s Bank of Boston. The event focused on the need to improve the nation’s financial literacy.
“Having a secure retirement is a high priority and a significant long-term goal for many Americans,” said Duke, “so it is especially important that they have an understanding of what level of resources they will need in retirement and the investment options available to them.”
So-called hardship withdrawals create permanent loss of retirement income, according to a Government Accountability Office study on 401(k) “leakage.” Losses stem from the tax consequences of hardship withdrawals and the missed opportunity for tax-deferred growth on assets held within a 401(k) plan. Employees generally lose the opportunity to contribute to their 401(k) for six months after making a hardship withdrawal. This embargo costs them additional tax savings and employer matches to 401 contributions.
A bi-partisan bill called the “SEAL Act” introduced in the Senate last month would waive the six-month waiting period for 401(k) contributions after making a hardship withdrawal.
“Hardship withdrawals are costly in the short term when you pay taxes. Over the long term, they also cost you when the withdrawn funds are not there to grow with the help of compounding,” states an Investor Alert from the Financial Industry Regulatory Authority.
So-called hardship withdrawals hit a record high of 7.1 percent in 2009 and stayed near that record in 2010, according to an AON Hewitt report on defined contribution plans. Between 2005 and 2010, hardship withdrawals increased 49 percent, said Duke, of the Federal Reserve, citing a Vanguard Group survey.
More than half of employees who made hardship withdrawals did so to avoid eviction or foreclosure, reported AON Hewitt. Educational and medical expenses were the next most common reasons for hardship withdrawals. Lower-income workers were more likely to take withdrawals.
Employer-sponsored 401(k) plans are not required to allow hardship withdrawals, though most do. Rules vary from plan to plan, but generally follow IRS guidelines that defines a hardship withdrawal as one used for an “immediate and heavy” financial need of an employee, or his or her spouse and dependents. Certain medical expenses, tuition and other educational expenses, payments to avoid eviction or foreclosure and funeral expenses can qualify.
The IRS requires employees to exhaust other resources before making a hardship withdrawal, including taking out the maximum allowable loan from a 401(k), and limits the hardship withdrawal to what’s needed to satisfy the need and pay for any taxes and penalties due. Hardship distributions are included in gross income unless they consist of designated Roth IRA contributions. The withdrawals may be subject to additional penalties and, unlike 401(k) loans, cannot be repaid to the plan. As the IRS explains in a fact sheet, “Thus, a hardship distribution permanently reduces the employee’s account balance under the plan.”