Cash Smarter

February 10, 2015  by: Aaron Crowe

Never Use a Retirement Account Like an Emergency Fund

Never Use a Retirement Account Like an Emergency Fund

Retirement accounts such as 401(k)s, IRAs and SEP-IRAs are meant to be used for what they’re named for: Retirement.

They’re not emergency funds to buy a home, repair a car, pay for college or pay off a medical bill. Yet those are some of the reasons people give for hardship withdrawals or for withdrawals when they’re not retired but past age 59.5 — the age when withdrawals are penalty free.

As defined benefit plans move to 401(k) retirement accounts, and those move into IRAs (Individual Retirement Accounts), more “leakages” from these retirement savings accounts are becoming more common, according to a February report by the Center for Retirement Research at Boston College.

Based on data from Vanguard, the study found a total leakage rate of 1.2 percent of assets from retirement accounts from four areas: Cashouts, hardship withdrawals, withdrawals after age 59.5, and loan defaults.

Tax penalties and delayed retirement

The immediate need of a hospital bill or home repair, among other short-term expenses, are some of the reasons why people pull money from their retirement accounts years before they should and long before they plan on retiring. Withdrawing the money early can not only lead to tax penalties, but to delaying retirement and having to work longer.

Even for people who don’t touch their retirement accounts until they’re retired, the account aren’t near the amounts they should be, the study found. In 2013, the typical working household with a 401(k) approaching retirement had only $111,000 in retirement assets.

Leakages reduce that wealth by about 25 percent at retirement, researchers found.

Types of retirement account leakages

Hardship withdrawals are allowed for an “immediate and heavy financial need” the report found. These include medical care, college, and avoiding foreclosure on a house.

Hardship withdrawals are generally subject to income tax, a 10-percent penalty tax, and 20 percent withholding for income taxes.

Withdrawals after age 59.5 don’t have a penalty. Most people will have to work past their mid-60s to ensure a secure retirement, and allowing early access to these funds undercuts the idea of preserving savings until retirement, researchers found. About 30 percent of such withdrawals represent leakages, they said.

Cashouts happen when an employee leaves a job and takes a lumpsum distribution from their retirement account. Other options are leaving it in the old employer’s plan, rolling it into an IRA, or transferring it to the new employer’s retirement plan.

Distributions through cashouts are subject to a 10 percent penalty tax if under age 59.5, and the 20 percent withholding requirement.

Loans are limited to 50 percent of the retirement account balance, up to $50,000. They generally must be paid back within one to five years.

Retirement account loans appear to encourage people who value liquidity to participate in their employer’s 401(k) plan and contribute more than they normally would.

But the loans come with risks. If it isn’t repaid due to default or job loss, the remaining balance is treated as a lump-sum distribution and subject to income taxes and the 10 percent penalty tax.

Impact on assets

Taking money out of a retirement account long before you plan to retire reduces your retirement funds by 25 percent, the Boston College researchers found.

For someone who started contributing 6 percent of their pay to a 401(k) at age 30, with a 50 percent employer match and an initial salary of $40,000, and a 4.5 percent annual return, the leakages would result in a retirement account of $203,000 at age 60 versus $272,000 with no leakages.

Policy options

Allowing retirement account participants access to their accounts for hardships encourages them to contribute to such plans, the study found.

Families with financial troubles should still be allowed access to their retirement accounts, but the withdrawals should be limited to serious, unpredictable hardships such as disability, high health care costs and job loss, the study recommends. Predictable needs such as housing and education would be excluded.

The 10 percent penalty tax could be eliminated, and the age for withdrawals could be raised to 62, an age closer to when people are retiring.

Lump-sum distributions at job termination could be eliminated, while the existing options for workers with retirement accounts would remain.

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