A growing number of Americans are tapping their 401(k) accounts early to cover emergency costs and even day-to-day expenses. However, advisors warn that early withdrawals should be a last resort, if not avoided altogether.
Jen Dawson, owner and managing director of Hemington Wealth Management, shared that a good rule of thumb is “waiting until you’re 60 so you can pull without any penalties,” from 401(k) accounts.
Withdrawals from 401(k) and traditional IRA plans before the age of 59½ result in a 10% penalty tax and income tax for individuals.
Dawson said maintaining emergency reserves so that pulling from retirement assets is a last resort is prudent advice. Individuals should be able to cover three to six months of their typical expenses with those emergency reserves, she added.
Individuals Tap Into 401(k)s Early for Various Reasons
While Dawson primarily works with higher net worth individuals in her practice, she has seen some instances of clients, and even friends, needing to break this rule of thumb and take an early withdrawal from their 401(k).
“I’ve seen it more when friends are in a personal season of life where they are going through a divorce,” Dawson said. She also recalls a client that was moving between houses and used an early withdrawal as a “short-term liquidity option,“ so they could close on their new home while waiting on the sale of their current one, she added.
Dawson recommends that retirement savers consider all options before going that route, however.
“One source of liquidity that people may not consider is a home equity line. And it’s not that I recommend that, necessarily – it would be something that is on top of your mortgage at a variable rate. [But] in an emergency, that would be something to explore rather than a 401(k) loan or early distribution,” Dawson said.
If all else fails and individuals feel they don’t have other options, Dawson suggests they should focus on their repayment strategy and longer-term financial planning to avoid having to make such moves in the future.
“The next thing I would shift to is: What is your plan to pay it back? There are payroll auto-deductions [for 401(k) loans], but could you have a faster plan of action, and not continue to get in trouble with having to spend more than your means?”
“The other thing that pops into my mind is the psychology of money and not beating yourself up too much. How can you focus on what’s good in your situation and, again, have a plan for rebuilding?” Dawson said.
Early 401(k) Withdrawals Increased in 2023
An annual survey by Vanguard found that usage of hardship withdrawals among its retirement plan participants had increased from 2022 to 2023. In 2022, 2.8% of Vanguard 401(k) plan participants had taken a hardship withdrawal, while that figure rose to 3.6% of participants in 2023.
The 2024 report also noted that “loan use increased slightly from 2022, however, it remained below the typical use rates of the years before COVID-19. Thirteen percent of participants had a loan outstanding, and the average loan balance was about $10,700.”
Another survey estimated that more than 40% of Americans may be pulling money early from their retirement savings.
Two out of every five adults reported making early withdrawals from their retirement accounts, inclusive of 11% of respondents who said they withdrew money from these types of accounts multiple times, a survey of 1,000 U.S. adults by FinanceBuzz found.
The top three reasons for these early withdrawals were personal debt (24%), recurring bills (21%), or a major purchase, such as a new home or vehicle (19%). Among those who had made early withdrawals, only 43% reported that they had paid back the amounts, the survey found.
Consider These Other Options Before Tapping the 401(k)
Chloé A. Moore, founder and principal of Financial Staples, also cautioned against tapping 401(k) savings ahead of your retirement years.
“Generally, I’d say don’t take early withdrawals from a 401(k),” Moore said. “There would be some alternatives you could tap into like an emergency savings. If it’s a medical expense you need to pay for, you could use an HSA [or health savings account], if it’s a covered medical expense.”
“If you have good credit, you can consider taking out a personal loan, especially if you’re able to get a competitive interest rate and it’s something you could pay back fairly quickly,” Moore added.
Individuals could also withdraw from a Roth IRA as an alternative, if they are facing an emergency expense or other unexpected costs. (This is as opposed to a traditional IRA, where early withdrawals are taxed and carry a 10% penalty.)
“If you have a Roth IRA, you could withdraw contributions without a tax or penalty, so that could be an option as well. You have other resources that aren’t going to penalize you as much,” Moore said.
Under the SECURE 2.0 Act, a new IRS rule took effect at the start of 2024 which allows retirement plan participants to make penalty-free early withdrawals of up to $1,000 per year. The exception was meant for “personal or family emergency expenses,” according to the Internal Revenue Service.
According to the survey by FinanceBuzz, most U.S. adults (more than 80% of respondents) weren’t aware of this IRS rule change allowing penalty-free withdrawals, however.
Preretirement Withdrawals May Worsen Gender & Racial Gaps
One negative consequence of pre-retirement withdrawals is that they may worsen gender and racial gaps in retirement savings, according to a March 2024 report by The Collaborative for Equitable Retirement Savings (a group started by the Defined Contribution Institutional Investment Association, the Aspen Institute Financial Security Program, and Morningstar Retirement).
The study noted that, “Black and Hispanic workers exhibit higher frequencies of preretirement withdrawals as well as a tendency to take larger percentages of their account balance, affecting the overall accumulation of retirement savings.”
Furthermore, the study determined that “eliminating preretirement withdrawals would substantially mitigate race and gender disparities, particularly for early- and mid-career 401(k) participants.”
Dawson emphasized the overall “financial freedom and peace of mind,” that comes with having a financial plan in place.
That may mean “having an advisor or (other) guidance,” she explained. “You don’t have to do this by yourself. Even if it’s a friend or family member that may be a sounding board. I think so often that people compound problems with shame or feeling alone in this,” Dawson added.
“In five or 10 years, you can have a clear vision of how (you’re) going to be OK and get out of this. Financial freedom is truly a lot of great small decisions that add up and make a huge difference in the long run. (I recommend) trying not to be too hard on yourself, and building a support system,” Dawson said.
For more news, information, and analysis, visit the Financial Literacy Channel.
