This is the fourth post in our series about promising proposals to advance retirement security in America.
Increasing access to and participation in workplace retirement savings plans is the first step to improving retirement security in the United States. These savings, however, are only meaningful for retirement if they actually last until then.
A recent study by the Federal Reserve found that less than half of adults could come up with $400 for an emergency without selling possessions or borrowing. This financial insecurity can cause many hard-working savers to prematurely withdraw funds from their retirement accounts—referred to as “leakage”—for unexpected needs, sacrificing current savings and future investment earnings.
Less than half of adults could come up with $400 for an emergency without selling possessions or borrowing.
Individuals have two ways that they can use their retirement savings to cover a short-term need: early withdrawals and borrowing. Early withdrawals from workplace retirement savings plans, such as 401(k) plans, are generally restricted to cases of hardship—known as “hardship distributions”—except when changing jobs. (Participants who leave employment may elect to cash out their retirement savings for any reason.) With few exceptions, such as experiencing a disability, withdrawals from a tax-deferred workplace plan before age 59 ½ are subject to both income taxes and an additional 10-percent early-withdrawal penalty (to discourage leakage). In contrast, savings in an Individual Retirement Arrangement (IRA) may be withdrawn at any time and for any reason. Additionally, early IRA withdrawals are exempt from the 10-percent penalty in many situations, such as to pay qualified higher-education expenses or to make a down payment on a first home. (Roth accounts are subject to special rules.)
The second option for accessing retirement savings, if the employer allows, is to take a plan loan. If this feature is offered by the plan, participants may borrow up to half of their account balance, subject to a ceiling of $50,000 (although employers may establish lower limits). Borrowers must repay the loan according to a certain schedule; if they default on their loan payments, the unrepaid balances are treated as cash-outs, which may be subject to income taxes and early-withdrawal penalties. Many plan-loan defaults occur when participants leave employment, at which point the entire outstanding loan balance must be repaid within 60 days.
While both forms of pre-retirement withdrawal have their merits in certain circumstances, they are over-utilized: one survey found that 44 percent of those who took out a plan loan regretted it, and another 23 percent said that, while they did not regret their decision, they would also not repeat it.
The Retirement Enhancement and Savings Act (RESA) of 2016, which was recently passed unanimously by the Senate Finance Committee (and previously written about by BPC), includes a few provisions that would affect leakage from retirement accounts. Some would reduce leakage, while one provision would increase the amount of retirement savings that can be withdrawn in case of hardship:
- Extend the period to pay back plan loans after changing jobs. As mentioned above, many borrowers default on plan-loan balances after the end of employment, turning a temporary loan into permanent leakage of savings. The RESA would extend the repayment window to the filing deadline for the tax year in which the participant left employment. For example, if an individual leaves employment at the end of February 2017 with a $5,000 outstanding plan-loan balance, he or she currently must repay the $5,000 by the end of April 2017 to avoid default and a taxable distribution. Under the RESA, the borrower would have until April 17, 2018 (tax day).
- Allow participants to continue contributing immediately after a hardship withdrawal. Currently, an individual who takes a hardship withdrawal from his or her workplace retirement savings plan is suspended from making contributions for six months. In some cases, the impact of this suspension is larger than the size of the hardship withdrawal itself. Enabling these individuals to continue contributing without interruption would minimize the negative impact of hardship withdrawals on their savings. This was a recommendation of BPC’s Commission on Retirement Security and Personal Savings.
- Allow withdrawal of employer contributions and earnings in case of hardship. Hardship withdrawals from workplace plans are currently limited to amounts that participants contributed themselves. Amounts contributed by an employer (through a matching or automatic contribution) cannot be distributed in event of hardship, nor can investment earnings, such as capital gains and dividends, resulting from either employer or employee contributions. While these limitations do reduce leakage, they also may exacerbate hardship, such as when a participant could avoid eviction or foreclosure through access to these savings. The RESA would remove this limitation and allow individuals who otherwise qualify for a hardship distribution to withdraw funds contributed by their employer and investment earnings, in addition to personally contributed funds.
More could be done to prevent leakage. For example, the recommendations of BPC’s commission included promoting personal savings for short-term needs so Americans are less likely to rely on retirement savings for emergencies, as well as harmonizing the rules for early IRA withdrawals with those for workplace plans. Nonetheless, these provisions in the RESA legislation are signs that lawmakers are looking closely at this important issue for retirement security.