Most retirement professionals do their best to discourage people from taking early withdrawals, but occasionally, circumstances arise where people need to withdraw funds from their 401k.
Doing so obviously has the potential to subject them to tax penalties, not to mention the likelihood of doing long-term damage to their retirement savings by spending cashouts or not repaying loans from a 401k.
A newly released U.S. Government Accountability Office report on retirement savings addresses policies and strategies that might reduce early withdrawals, such as building emergency savings features into retirement plans (more on that below). The report also recommended improving information about defaults on retirement account loans by revising Form 5500 to require plan sponsors to report the incidence and amount of all 401(k) plan loans that are not repaid.
For both IRAs and 401k plans, GAO was asked to examine: (1) the incidence and amount of early withdrawals; (2) factors that might lead individuals to access retirement savings early; and (3) policies and strategies that might reduce the incidence and amounts of early withdrawals.
To answer these questions, GAO analyzed data from IRS, the Census Bureau, and DOL from 2013 (the most recent complete data available); and interviewed a diverse range of stakeholders identified in the literature, including representatives of companies sponsoring 401k plans, plan administrators, subject matter experts, industry representatives, and participant advocates.
In 2013, participants in employer-sponsored plans like 401ks withdrew at least $29.2 billion early as hardship withdrawals, lump sum payments made at job separation (cashouts), and loan balances that borrowers did not repay. Hardship withdrawals in 2013 were equivalent to about 0.5% of the age group’s total plan assets and about 8% of their contributions.
Report author Charlie Jeszeck, an expert on retirement security, pensions and Social Security at the GAO, noted how the ability to withdraw 401k money in an emergency and the need to save for retirement are competing objectives, and current plans often hamper plan participants from reconciling the two.
“Ideally what we want to do is increase the flexibility in the system to help individuals balance both of those two objectives,” Jeszeck said in a GAO podcast about the report. “There are some strategies out there—increasing financial literacy making individuals more aware of this tradeoff; giving employers the flexibility to provide alternatives; minimize the adverse effect of leakage—all those things can work together to help individual participants meet both of these challenges.”
Jeszeck admits there are legitimate cases when it is necessary to take money out of a plan. “For example, a short-term emergency, or with some of the big storms we’ve had there are cases where people need to repair their homes; there could be medical expenditures or a sudden problem with your car; so there are reasons why you might want to take the money out,” he said.
But there are ways to prevent these withdrawals from wreaking havoc on the participants retirement savings. “There’s a lot of things that can be done. With cashouts, rather than simply sending a check to the individual who may not roll it over and have to pay tax on it, they can give partial distributions, and spread it out over a number of months. In a lot of cases, the individual may leave the remainder in the plan, and so it still accumulates for their retirement,” Jeszeck said.
Stakeholders said that certain plan rules, such as setting high minimum loan thresholds, may cause individuals to take out more of their savings than they need. Stakeholders also identified several elements of the job separation process affecting early withdrawals, such as difficulties transferring account balances to a new plan and plans requiring the immediate repayment of outstanding loans, as relevant factors.
“A big problem with loans is that if you have a loan and you separate from a company, if you can’t pay the loan back immediately in full, you’ll have to pay tax on that,” he said. “So creating a situation where the employee is at a new company but can continue to pay the loan back at the old company through an extended repayment plan is a way to avoid unnecessary withdrawals from the system and allow the participant to replenish their savings and continue to save for retirement.”
GAO recommends changes to Form 5500
However, the GAO report said the incidence and amount of certain unrepaid plan loans cannot be determined because the Form 5500—the federal government’s primary source of information on employee benefit plans—does not capture these data.
To better identify the incidence and amount of loan offsets in 401k plans nationwide, the report recommends that the Secretary of Labor direct the Assistant Secretary for the Employee Benefits Security Administration, in coordination with IRS, to revise the Form 5500 to require plan sponsors to report qualified plan loan offsets as a separate line item distinct from other types of distributions.
Building emergency savings into 401ks
Here’s a closer look at one of the suggested strategies from stakeholders GAO interviewed for the report, focused on how building emergency savings features into plan designs could help preserve retirement savings:
- A portion of participant’s contributions to a 401k plan is directed to an emergency savings account
- When emergency savings threshold is met, subsequent contributions are directed to a 401k plan
- When faced with an economic shock, participant may withdraw emergency savings
- Afterwards, a portion of contributions is again directed to replenish emergency savings
The report notes GAO is not endorsing or recommending any strategy, and has not evaluated these strategies for their behavioral or other effects on retirement savings or on tax revenues.