Early Withdrawals From 401(k)s Should Be A Last Resort

By Michael Wilbert

When Tom Petty and the Heartbreakers recorded All The Wrong Reasons nearly 30 years ago, they weren’t talking about why today’s employees are withdrawing from their retirement accounts.

But they did hit the nail on the head about one thing – those withdrawals are mostly for all the wrong reasons. That’s because financially stressed employees often turn to withdrawals from their retirement savings to fund unexpected expenses or just to keep up with their monthly expenses.

All of the effort employees make to sock away money for retirement is erased when they make early withdrawals from their accounts. Usually, withdrawals made before age 59½ come with a 10% penalty. Some early distributions (hardships, higher education expenses and buying a first home) qualify for a waiver of that penalty, but the withdrawal nevertheless is taxed. The CARES Act allows withdrawals without the 10% penalty right now.

With many Americans living longer into their post-retirement years, they need all the retirement savings they can get. According to 2019 Charles Schwab research, 72% of Americans who are within five years of retirement worry they will run out of money during their post-work years. And it takes money to truly enjoy retirement – staying healthy, keeping up a home, taking trips and being able to afford both necessities and the occasional luxuries.

There is some encouraging news for younger workers. Principal’s 2019 Driving Plan Health report reveals that millennials have increased their total contribution rate in their 401(k)s by 23% over the past six years and lead the way among the generations in proper account diversification.

There also was good news from the IRS regarding an increase in the maximum annual contribution rate as of Jan. 1, 2020. However, all of the raised limits in the world aren’t going to help if employees are withdrawing from their funds before retirement.

Who’s Borrowing From Their 401(K) And Why?

Here’s a snapshot of 401(k) withdrawals before the pandemic hit this year. Results of a survey conducted by The Harris Poll on behalf of Purchasing Power in December 2019 among 807 U.S. adults who are employed full-time reveals that 21% of those with a 401(k) had borrowed from it in the last 12 months. About two-thirds (63%) of those who did so were women.

It’s interesting to see the salary ranges for those who borrowed from their 401(k) during 2019:

Less than $50,000 – 11%
$50,000 - $74,999 – 17%
$75,000 - $99,999 – 29%
$100,000 – 25%

The survey also asked what employees how they used their 401(k) withdrawals in 2019. The answers show that workers are turning to their retirement funds mostly to cover unexpected, emergency expenses. Withdrawals were used for:

Vehicle repair/replacement – 41%
Funeral travel or an unexpected move – 36%
Replacing or upgrading a major home appliance that stopped working – 33%
Medical costs such as a sudden illness - 31%
Home repairs – 31%
Education expenses – 28%
Down payment on a home – 18%

Employees who turn to borrowing from their 401(k) to meet short-term needs will not have as great an opportunity to build wealth for their later years. They will have to repay the loan with after-tax dollars, plus they lose the investment earnings on the money while it’s out of the account.

If they fail to repay the loan, the amount owed converts to a withdrawal, and tax and penalties will be due. Furthermore, if they change jobs with an outstanding 401(k) loan debt, the full amount will be due within 60 days, or the IRS will treat the loan as an early withdrawal and charge taxes plus a 10% penalty fee.

Granted, life happens and unexpected expenses arise, but employees need a lifeline for these bumps in the road that doesn’t involve borrowing from their retirement future.

COVID-19 Financial Stress And 401(k)s

There’s no question that COVID-19 has thrown a curve ball into our entire lives and our financial situations. The “new normal” from the effect COVID-19 is having on jobs and the economy has created even more financial stress. Employees are worried more than ever about money. In fact, a March 17 FinanceBuzz study showed that Americans were more worried about unexpected expenses (79%) and paying their bills (68%) than they were about catching COVID-19 (63%).

Employees who are laid off or furloughed may be pausing their retirement contributions right now. It’s possible they will be able to ramp up those contributions once they are back at work and even increase their savings rate to make up for the missed contributions. Other employees may need to make withdrawals in order to cover basic expenses during the pandemic and until they are drawing a paycheck once again. Withdrawals during the pandemic are penalty-free due to the CARES Act.

Alternatives To Withdrawals

The bottom line is that withdrawals should be made from 401(k)s only as a last resort. Likewise, employees should avoid other methods of handling a gap in income that could have serious long-term ramifications, such as high-interest credit cards and payday, auto or other short-term loans that can carry interest rates upward of 600% and easily sink borrowers into an inescapable debt cycle, wreaking havoc on their credit score.

Employees should explore all alternatives prior to withdrawing from their 401(k) whether it’s during this pandemic or anytime. During this COVID-19 pandemic, many creditors are willing to delay payments, so employees should be sure to check all options.

Another option is to take advantage of any voluntary benefits that are part of the employee benefits program. Often, employees aren’t aware some of these benefits exist. This is a good time for benefit communications about options in the employee benefits plan that might be helpful during this time. These benefits may include low interest installment loans and credit as well as employee purchase programs that allow workers to purchase consumer products and services through payroll deduction.

Using voluntary benefits such as employee purchase programs to obtain needed household items when the refrigerator breaks or a computer dies allows employees to ensure that they are using their 401(k) plan for what it is meant to be – savings for their golden years.

These alternatives to borrowing from a 401(k) can really make a difference when it comes to surviving and thriving in the retirement years. Let’s continue to look for ways to help keep short-term financial stress from derailing long-term investment strategies.

Michael Wilbert is chief revenue officer at Purchasing Power, a voluntary benefit provider. He has 30 years of experience in the insurance and voluntary benefits industry. He may be contacted at [email protected].