A new study reported in the press summarizes what retirement experts have known for a while: Tax-deferred retirement accounts such as 401(k)s and IRAs can sometimes be “leaky buckets,” meaning that some individuals tap their tax-advantaged accounts prior to retirement. This study triggered a couple of thoughts in my mind about the ways you can tap 401(k)-style accounts before retirement.
First, through 401(k) loans. There’s endless fascination with the dangers of 401(k) loans, but from my perspective, it’s misplaced. In 2010 (the last year with comparable data), 401(k) loans outstanding totaled $57 billion, while total consumer debt reached $2.5 trillion (sources: Department of Labor, Federal Reserve). In terms of aggregate financial risks to American households, 401(k) loans are negligible. What’s more, as our data show, nearly 90% of 401(k) loans are repaid. As a colleague of mine is fond of pointing out, who’s more at risk—the 401(k) account holders with a loan or the tens of millions of workers who don’t save in their employer’s plan in the first place?
Second, hardship withdrawals. You can typically access some of your 401(k) money if you face a hardship such as receiving a foreclosure or eviction notice. This is one reason withdrawals jumped during the recent crisis. But Congress has a fairly expansive definition of “hardship,” which can include paying college tuition or buying a first home.
When taking a hardship, you’re generally restricted to tapping your own contributions, so you can’t fully deplete your account. (Investment earnings on your own contributions can’t be touched, and employer money is restricted in many plans.) Hardships are only taken by a small fraction of participants, but like loans, they receive an inordinate amount of attention.
The third type of leakage is cash-outs when changing jobs. This is by far the largest source of outflows, according to government statistics. It’s rightfully the main focal point of concern, although top-line statistics tend to be exaggerated. (Most reports of high rates of cash-outs fail to account for workers who change jobs and leave their money in their former employer’s plan.)
The U.S. system is unique in the flexibility it gives workers. Generally speaking, you can access your entire vested account balance when you change jobs, with one proviso: If you tap that money, you’ll owe income taxes plus a 10% penalty if under age 59 1/2. Still, as I’ve written about in a previous post, if you’re in dire financial straits today with no other resources, or if you have generally poor saving and planning skills, you’re likely to turn to your retirement savings and pay the taxes and penalty.
A few years ago, researchers at a tax conference estimated the cost of all types of leakage at 1 out of every 7 dollars. In other words, in a given year, for every $7 of new contributions that flow into tax-deferred accounts, $1 leaks out (mostly through cash-outs, but also through loan defaults and hardships). That’s a 14% loss rate. This seems like a pretty large number. During the years surrounding the great recession, these numbers were likely worse.
We could take steps to reduce leakage. For example, Congress could reduce the size of loans, narrow the types of hardships, up the penalty tax, or prohibit account owners from cashing out part of their account until retirement age. All of these would improve retirement security for some savers.
The challenge, of course, is that one person’s leakage is another person’s financial safety valve.
Pre-retirement access to savings is a valuable option, and it makes saving in a tax-deferred plan more attractive in the first place. Increase the restrictions, and contributions may fall (though by how much is a debatable point). Even Congress is of mixed minds on the issue: Taxes and penalties on withdrawals were waived for victims of hurricane Katrina, and the same idea was brought up (but not implemented) for victims of superstorm Sandy.
While leakage is a policy question for Washington, it’s also a practical issue for individuals. The standard advice is clear. To maximize retirement resources, a critical step—besides saving generously, diversifying investments, and keeping costs low—is to minimize pre-retirement access. In short, if you spend it today, it won’t be there tomorrow. I think that’s generally good advice, but as another media article makes clear, it’s not always uniformly true.
One final thought. When the topic of leakage comes up, there’s sometimes indirect finger-pointing at the 401(k) industry. I’ve been working in the retirement field for over two decades, and I can’t think of a single moment at an industry gathering when someone got up and talked about the merits of cashing in retirement accounts. Most 401(k) and IRA companies would love to have more, not less, money to manage.
If we were to move in the direction of greater restrictions on retirement accounts, it’s clear that costs would be involved and that important trade-offs would have to be weighed. Hand-wringing about who’s responsible for leakage only detracts from the issue.