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More Americans are tapping into their 401(k) to make ends meet — treating it more like an emergency fund than a retirement savings plan.
Hardship withdrawals are running 15% to 20% above the historical norm, according to Empower CEO Ed Murphy. Empower is the second-largest retirement plan by participants in the U.S.
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While new rules make it easier to withdraw funds, some people may be turning to their retirement savings as prices on consumer goods — from groceries to cars — tick upward.
“There is a corollary to what you are seeing in the U.S. economy with deferred payments on auto loans and mortgages,” Murphy told Bloomberg TV. “So that’s something we monitor carefully.”
A hardship withdrawal allows you to withdraw money from your 401(k) to cover an “immediate and heavy financial need,” according to the Internal Revenue Service (IRS).
Some people may be making this decision based on financial hardship, such as housing or medical debt. A new report from Vanguard noted similar findings to Empower, with 4.8% of 401(k) participants initiating a hardship withdrawal in 2024 — up from 3.6% in 2023.
While there are a few “signals of a possible uptick in financial stress,” the report says that for some workers, hardship withdrawals “may serve as a safety net that otherwise may not have been available without plan-implemented automatic solutions.”
Add to that the possibility of heading into a recession, with consumer confidence plummeting and more Americans may find themselves struggling to pay the bills.
“We encourage people to have an emergency savings account, have at least two years of expenses set aside in the event these types of situations occur,” Murphy told Bloomberg TV.
Even the IRS is prepared for an increase in hardship withdrawals, stating on its website that “given the current economic climate, a greater number of participants may be requesting hardship distributions from their retirement plans.”
Hardship withdrawals typically come with steep penalties. On top of federal and state income taxes, you might be required to pay a 10% tax on early withdrawals if you are under 59 ½.
Rather, consider building an emergency savings fund to manage unexpected expenses. This way, you don’t have to worry about cashing out your retirement savings during a market downturn or the tax implications of an early withdrawal.
You can make your emergency savings work harder for you by parking them in a high-yield savings account.
Even with this, it can take years to see your savings account reach its full potential. But if you own a home — and have been making regular mortgage payments — chances are you’ve built up solid equity.
With home values higher than ever, you can make your home work harder for you by making the most of your equity. The average homeowner sits on roughly $303,000 as of the fourth quarter of 2024, according to CoreLogic.
Having access to your home equity could help to cover unexpected expenses, pay substantial debt, fund a major purchase like a home renovation or supplement income from your retirement nest egg.
Rates on HELOCs and home equity loans are typically lower than APRs on credit cards and personal loans, making it an appealing option for homeowners with substantial equity.
The amount you can withdraw is limited to only what’s necessary to “satisfy that financial need,” according to the IRS.
You may be able to avoid the early withdrawal penalty if you meet the IRS’s eligibility for safe harbor distributions, such as the pending foreclosure of your home. But it won’t get you out of paying taxes.
The money you withdraw from your 401(k) is taxable income. This means drawing down on your 401(k) could slingshot you into a higher tax bracket. There are also longer-term consequences, such as the loss of compounding growth, which could hinder your retirement goals.
That’s why a hardship withdrawal is usually considered a last resort.
If you’ve already eaten through your emergency fund, there are still some options you could consider before a hardship withdrawal. For example, you could look for ways to reduce expenses — like cancelling an upcoming vacation or selling a second vehicle.
Monthly insurance premiums on your home and car might also be eating into your take-home pay. With premiums expected to rise, you might want to lock in a lower rate now.
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If you decide to make a hardship withdrawal, it’s worth consulting a financial advisor so you fully understand how it will impact you now and in your golden years.
One option is to find an expert through Advisor.com.
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
