Tapping your 401(k) early to pay bills? There may be another way.
Americans who lack emergency funds have been, in large numbers, draining their retirement funds to pay bills.
It’s not a surprise: This trend has been gaining steam for a few years now. But that doesn’t make it any less worrisome.
"All it takes is one financial shock — like a major car repair or an unexpected illness—to destabilize a household," Craig Copeland, director of Wealth Benefits Research at Washington, D.C.’s Employee Benefit Research Institute (EBRI), told Yahoo Finance.
That’s the bad news. The good: Help may be on the way courtesy of the federal government.
But first, some background.
Taking a loan from retirement savings is one way to get your hands on cash quickly. It’s not, however, generally the first place people turn. When hit with a spending spike, 3 in 5 households increased their credit card debt and then took out a 401(k) loan, according to a new report by EBRI and JPMorgan Asset Management.
Read more: What happens if I only pay the minimum payment on my credit card?
That said, 17% of those faced with the blow of unanticipated bills tap funds in their 401(k) plan loan compared with 7% of those without those unplanned expenses, according to the EBRI and JPMorgan Asset Management findings.
The research uses data from 29 million Chase households and 11 million 401(k) plan participant records between 2016 and 2020.
A stunning 9 in 10 households encountered at least one spending spike in a given year that could not be covered by their current income, according to the report. One in 3 households experienced at least one spending spike above their income and cash reserves. For 3 in 4 households with income under $150,000, a spending increase above $2,500 could not be funded by income alone.
There are, of course, repercussions to using your retirement stockpile for short-term expenses over long haul savings. The main drawback is that by pulling funds out, even for a few years, your retirement funds lose out on compounding growth on that sum for workers.
This is tempting when you’re in a pinch. And for most people, the loans from the workplace plans are a better option than a bank loan or ratcheting up high-interest credit card debt.
Depending on what your employer's plan allows, you can take out as much as 50% of your savings, up to a maximum of $50,000, within a 12-month period. With a loan, you borrow money from your retirement savings and pay it back to yourself, usually within five years, with interest — the loan payments and interest go back into your account.
One caveat: If you leave your current job, you might have to repay your loan in full fairly quickly. Should you not be able to repay the loan taken from your tax-deferred account, you'll owe both taxes and a 10% penalty if you're under 59 ½.
A big reason for the uptick in borrowing from a retirement plan is there is nowhere else to turn. Nearly a quarter of consumers have no savings set aside for emergencies, according to the Consumer Financial Protection Bureau. And that’s a problem that plays out with unmanageable credit card bills, and people borrowing from their retirement accounts, or taking early withdrawals.
Read more: How to find out your 2024 Social Security COLA increase
Starting next year, though, many American workers will have access to a new job benefit: help with saving for these out-of-the-blue outlays.
In 2024, the SECURE 2.0 Act will introduce a provision to help employees increase their emergency savings while also saving for retirement. Employers may offer non-highly compensated employees an option to link their retirement plan to an emergency savings account.
For the 2024 plan year, an employee who earns more than $150,000 in 2023 is a highly compensated employee, according to the IRS. That amount changes annually.
Workers who qualify and have a defined contribution retirement plan, such as a 401(k), will be able to add an emergency savings account that’s a designated Roth account to set aside contributions. Contributions will be limited to $2,500 annually (or lower, as set by the employer).
You’ll be able to take out funds at least once a month and the first four withdrawals in a year will be tax- and penalty-free. Moreover, you won’t have to provide proof of a qualifying emergency cause.
Depending on plan rules, contributions may be eligible for an employer match. Once the cap is reached, additional contributions can be directed to the employee's defined contribution plan or put on hold until the balance dips below the limit, at which point you can start contributing again. The IRS is expected to provide additional guidance on these accounts before the end of the year.
"Having a financial cushion can prevent families from starting a pattern of having to take on more credit card debt or loans to cover their expenses," Copeland said. "The emergency savings provisions in SECURE 2.0 can make all the difference for families’ finances, particularly for those that are living paycheck-to-paycheck."
Kerry Hannon is a Senior Reporter and Columnist at Yahoo Finance. She is a workplace futurist, a career and retirement strategist, and the author of 14 books, including "In Control at 50+: How to Succeed in The New World of Work" and "Never Too Old To Get Rich." Follow her on Twitter @kerryhannon.
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