In an article in The Wall Street Journal back on July 21, 2024, Gina Heeb and Kailyn Rhone confirm that America’s borrowers are on ever more shaky ground.[i] Day to day, a majority of Americans live paycheck to paycheck[ii] or worse, they become another day older and deeper in debt[iii].
Many low- and middle-income households have exhausted the glut of deficit-financed cash distributed during/after the pandemic.
Due to inflation, and the response of the Federal Reserve Bank, the borrowing costs for a home, a car or a credit card are at the highest levels in decades. The total amount of interest consumers paid on mortgages in 2023 rose 14% from a year earlier and interest jumped 50% for other types of consumer debt, such as credit cards and auto loans. (See Drowning in Debt sidebar)
Maxed out? Next Liquidity Source May Be Your 401k!
In a study that examined leakage for periods prior to recent legislation, the Joint Committee on Taxation confirmed that 22% of net contributions to 401k plans by workers under age 50 leak out of the system each year[iv].
For comparison, leakage may be even greater in some state-mandated Roth IRA programs.[v]
Unfortunately, now that most of SECURE 2.0 provisions have taken effect[vi], many plan sponsors will voluntarily add new leakage options[vii] – “just in time” to exacerbate the debt challenge.
Resist!
Plan sponsors should resist adding the new “liquidity with leakage” features authorized by recent legislation. Instead, plan sponsors should head in the other direction and eliminate hardship withdrawals—curtailing pre-retirement leakage. Concurrently, plan sponsors should require their service providers to update plan loan processing to 21st Century functionality.
Plan sponsors should require their service providers to update plan loan processing to 21st Century functionality.
For those who have access to an employer-sponsored plan and who are participating, the most effective solution to the “retirement crisis,” the best option for increasing household wealth and retirement assets may be to minimize leakage—replacing withdrawals that are always leakage with plan loans “done right” that are seldom leakage.
Plan loans, “done right,” can effectively address emergencies, student loans, most indebtedness—and do so at a lower cost and in such a way as to improve BOTH household wealth AND retirement preparation.[viii]
My bet is every reader of this article pays at least one bill using electronic banking functionality. Payroll deduction is so 20th Century! Why should plan sponsors continue to require participants to make loan payments via cumbersome payroll deduction processes, costly to set up and more expensive to administer? Why use a process that prompts workers to default on plan loans when changing employers?
21st Century loan processing, “done right” would also embrace a line-of-credit structure and various behavioral economics concepts, features, and processes.
Consider also that all assets in Individual Retirement Accounts (IRA)[ix] are liquid and that the penalty tax is insufficient to deter use prior to retirement[x]. Leakage from IRAs can be avoided or reduced by encouraging participants to retain assets in the employer-sponsored plan to leverage tax-preferred without leakage liquidity via 21st Century plan loan processing.
No mas!
Legislation over the last five or so years added many new pre-retirement withdrawal options—confirming that Congress believes in more leakage. [xi] It is past time for Congress to reverse direction and curtail pre-retirement distribution options in favor of improving liquidity options that don’t always trigger leakage—updating plan loan maximums[xii] (as the irrational limits only apply to successful savers with whose account balance exceeds $100,000).
I always appreciate your comments, concerns, criticisms, or questions. Connect with me on Linked-in or contact me at: jacktowarnicky@gmail.com
Disclaimer No. 1: My comments are my own based on my past experiences in plan sponsor and consulting roles and do not necessarily reflect those of any employer or association I have been employed by or affiliated with, past, present, or future.
Disclaimer No. 2: Information was provided by individuals with knowledge and experience in the industry and not as legal or tax advice. The issues presented here may have tax and legal implications, and you should discuss this matter with tax and legal counsel prior to choosing a course of action. This article is intended to be informational only. It is not and you/others should not use it as a substitute for legal, accounting, actuarial, tax or other professional advice. Any advice contained in this article was not intended or written to be used and cannot be used by anyone for the purpose of avoiding any Internal Revenue Code penalties that may be imposed on such person [or to promote, market or recommend any transaction or subject addressed herein. You (others) should seek advice based on your (their) particular circumstances from an independent tax
[i] G. Heeb, K. Rhone, American Borrowers Are on Shakier Ground. These Charts Show Why, Years of higher inflation and interest rates have left consumers mired in debt, even as overall economy hums, Wall Street Journal, 7/21/24, Accessed at: https://www.wsj.com/finance/credit-card-debt-loans-high-interest-rates-8da11e83?mod=hp_lead_pos5
[ii] PayrollOrg, Getting Paid in America, September 2023. “The annual survey asked respondents how difficult it would be to meet their financial obligations if their paychecks were delayed for a week. Of the 38,605 individuals who responded to this question, 30,225 respondents, or 78 percent, said they would find it somewhat or very difficult to meet their financial obligations.” Accessed 7/21/24 at: https://www.prnewswire.com/news-releases/survey-reveals-six-percent-increase-in-americans-living-paycheck-to-paycheck-in-just-one-year-301928853.html
[iii] Tennessee Ernie Ford, 16 Tons. Accessed 7/21/24 at: https://www.youtube.com/watch?v=RRh0QiXyZSk
[iv] Joint Committee on Taxation, Estimating Leakage from Retirement Savings Accounts, 4/26/21. The left side are contributions by individuals (excluding employer contributions), the right side are distributions to individuals. Rollovers are substantial, but also excluded. The size of the gray areas is proportional to the magnitude of the flows. For this study, leakage is the age 0 – 50 box on the right side. Accessed 4/11/24 at:
www.jct.gov/CMSPages/GetFile.aspx?guid=ed1c9da4-f180-41cd-b3f9-b8afb9531d18
[v] OregonSaves, Monthly Dashboard as of July 31, 2024. July contributions: $9,604,208, Withdrawals $4,239,528 (44%). June contributions: $7,293,856, Withdrawals $3,837,375 (53%). Accessed 8/21/24 at: https://www.oregon.gov/treasury/financial-empowerment/Documents/ors-board-meeting-minutes/2024/2024-07-Program-Report-OregonSaves-Monthly.pdf
[vi] J. Towarnicky, Is Congress Mad? Are You? SECURE 2.0 adds a variety of new leakage opportunities, Jack Towarnicky argues. Congress has made up its mind. Your turn. 401kSpecialist.com, 2/3/23, Accessed 7/21/24 at: https://401kspecialistmag.com/is-congress-mad-are-you/ See also: J. Towarnicky, Congress: Did You Ever Have to Make Up Your Mind? Are the tax preferences for assets in retirement savings plans intended for retirement? If so, you may want to stop proposing legislation that enables and encourages leakage, 401kSpecialist.com, 9/21/22, Accessed 7/21/24 at: https://401kspecialistmag.com/congress-did-you-ever-have-to-make-up-your-mind/
[vii] J. Towarnicky, A “Leakproof” Retirement Savings Plan, Benefits Quarterly, 3rd Quarter 2024.
[viii] J. Towarnicky, Qualified Plan Loans, Evil or Essential? Benefits Quarterly, 2nd Quarter 2017, See also: J. Towarnicky, Debt or Deferrals … College or Contributions? A 401(k) Can Do Double Duty, Benefits Quarterly, 3rd Quarter 2019, See also: J. Towarnicky, Adding a Sidecar Savings Account for Emergency Savings? Better Solutions May Exist, Benefits Quarterly, 1st Quarter 2022.
[ix] According to the Investment Company Institute Fact Book, 2024, “IRA assets totaled $13.6 trillion at year-end 2023, accounting for 35 percent of US retirement market assets. More than four in 10, or 56 million, US households owned IRAs in 2023. Accessed 7/21/24 at: https://www.ici.org/system/files/2024-05/2024-factbook.pdf
[x] J. Beshears, J. Choi, C. Clayton, C. Harris, D. Laibson, B. Madrian, Optimal Illiquidity, July 2020. Author’s Note: Illiquid retirement savings are desirable to avoid under-saving and self-control issues. This study shows optimal illiquidity to achieve equilibrium in a 401(k) plan requires a 13% early withdrawal penalty to account for present bias. However, our current 10% penalty tax does not apply to all withdrawals, it is not assessed promptly, so it is ineffective in application, in size and in timing. And, even properly applied, increased to 13% instead of 10% and timed to occur coincident with the withdrawal, a plan at equilibrium does not reduce withdrawals and distributions – what I term “leakage by commission”. Accessed 4/11/24 at www.nber.org/papers/w27459
[xi] Author’s note: New leakage opportunities were added by the Bipartisan Budget Act of 2018 which made more assets available for hardship withdrawals, SECURE which allows for penalty-free withdrawals for birth or adoption, CARES which eliminated hardship requirements during COVID, and CAA which added withdrawal provisions after a federally declared disaster.
[xii] The Internal Revenue Code §72(p) loan maximums of $10,000 and $50,000 have been in place 30, 40, 50 or more years. Form 5500 data shows that: (1) The average assets in defined contribution accounts in 1975 was $6,541, (2) The average assets in 401k accounts in 2021 was $83,325, so (3) Had the $10,000 and $50,000 amounts been indexed to match the growth in the average account balance, they would be $127,389 and $636,945, respectively. (Author’s calculation). Form 5500 data accessed 8/21/24 at:https://www.dol.gov/sites/dolgov/files/EBSA/researchers/statistics/retirement-bulletins/private-pension-plan-bulletin-historical-tables-and-graphs.pdf