The toll inflation is continuing to take on Americans has translated to a record number of people taking 401(k) “hardship withdrawals,” according to new data, a phenomenon which Vanguard called “concerning.” In turn, this move could potentially have a longer-term negative impact and could mean difficult years when these Americans enter retirement.
While certain retirement plans allow participants to receive so-called hardship withdrawals, or distributions, they can only be made if the distribution is both due to an immediate and heavy financial need — and limited to the amount necessary to satisfy that financial need — the Internal Revenue Service (IRS) explained on its website.
These include (but may not be limited to):
- expenses for medical care.
- costs directly related to the purchase of a principal residence for the employee.
- payment of tuition, related educational fees and room and board expenses, for up to the next 12 months of post-secondary education for the employee, the employee’s spouse, child or dependent.
- payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
- payments for funeral expenses for the employee’s spouse, children or dependent.
- expenses for the repair of damage to the employee’s principal residence.
As of October, the new Vanguard data indicated that these hardship withdrawals reached an all-time-high, perhaps unsurprising given a turbulent economic environment plagued by high inflation. This retirement plan withdrawal behavior shows signs of increasing financial strain among U.S. workers, Vanguard suggested.
Taking 401(k) Hardship Withdrawals Can Be Dangerous
Ted Rossman, senior industry analyst at CreditCards.com, said that dipping into your 401(k) early is generally not advised for two reasons: financial penalties and losing out on future growth.
“I know sometimes desperate times call for desperate measures, but there’s also the long-term component to consider. Rather than trying to time the market, which is notoriously difficult, it’s usually best to be in the market for as long as possible,” said Rossman. “Every dollar you set aside for retirement in your 20s or 30s might be worth $15 or $20 by the time you retire. But if that money is not invested, it’s not growing. I know the market has been down so far this year, but when it bounces back, the gains could come quickly.”
If you’re facing an urgent financial need, he advised considering alternatives before raiding your retirement account.
“For example, could you qualify for a low-rate personal loan? Borrow from family or friends? Take advantage of a 0% credit card promotion? Take on a side hustle? Sell stuff you don’t need? Cut your expenses? Dip into savings? Tap some home equity?” he said, adding that he’d “put a lot of other things ahead of borrowing from a retirement plan if possible.”
Several experts echoed that sentiment, including Mike Shamrell — vice president of workplace thought leadership, Fidelity Investments. Shamrell noted that when a serious financial emergency occurs, the important thing to do is to sort through the options you have available (such as any emergency savings you may have saved) and then determine whether you qualify for a hardship withdrawal.
“The IRS has very clear guidelines on what would be considered a hardship withdrawal, and individuals should also understand the impact it will have on retirement savings and your long-term retirement preparedness,” Shamrell said, adding that among Fidelity 401(k) participants, the number of individuals taking a hardship withdrawal is still relatively low, although it has increased slightly over the year.
In 2021, about 1.9% of 401(k) participants took hardship withdrawals annually — while from January through October of this year, that number increased to 2.2% of total participants.
In addition, it’s important to note that with hardship withdrawals, you cannot repay funds to the plan, or roll them over to another plan or IRA. CNBC noted that many employers disallow workers from contributing to their 401(k) for six months after taking a hardship distribution.
Non-hardship withdrawals also were high in October, reaching 0.9%, the Vanguard data showed.
Experts Largely Agree That Taking 401(k) Hardship Withdraws Rising, But Ill-Advised
Bobbi Rebell, author of “Launching Financial Grownups” and personal finance expert at Tally, said that while it’s important to note that these numbers remain a small percentage, the increase is a big concern given the economic trends.
“Most Americans are already saving and investing far less than what they need to meet their retirement goals. Taking money away from that not only makes it that much harder down the road — it also can create a perception that these retirement funds are, effectively, an emergency fund,” Rebell said.
Rebell noted that taking money out can also create a problem if the employee leaves the job or is fired — and then has to pay it back much faster than planned.
“If they don’t, they face fines and penalties. It may also make an employee feel they have to stay with their current employer even if a better opportunity comes their way — because leaving would result in having to come up with the cash in a short time frame,” she added.
Another concern is the gap that happens in terms of putting new money in if you take a loan from your account, and potentially the lost company matching funds.
“Many companies don’t allow new contributions until the loan is paid back, so that is something that might never be recovered. The money is not compounding for that time. In other words, it is a lost opportunity that can be very expensive,” she added.
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