The New Rainy Day Fund: Your 401k
Key Take-aways:
- 4.8% of 401k account holders took hardship withdrawals in 2024, up from 3.6% in 2023 and pre-pandemic average of about 2%
- Auto-enrollment in 401k plans has increased, which may contribute to the rise in withdrawals as more people are enrolled who may not be ready to save for retirement
- In 2018, the requirement to take a loan before applying for a hardship withdrawal was eliminated
- Starting in 2022, the IRS created a provision allowing people to take a one-time $1000 distribution as a hardship withdrawal annually
- The increase in hardship withdrawals may not necessarily indicate financial distress, as rules have been loosened regarding what qualifies for these withdrawals
- When taking a hardship withdrawal, taxes can be withheld or paid later at tax time, along with any applicable penalties
Timestamps:
00:18 Rising Trend in Early Withdrawals
00:44 401(k) Basics and Rules
01:49 Impact of Auto-Enrollment
04:15 Rule Changes Affecting Withdrawal Rates
06:24 Tax implications of Rainy Day fund withdrawals
06:58 Does this imply the consumer is in trouble?
The New Rainy Day Fund: Your 401k – Links
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WSJ article: The 401k Has Become America’s New Rainy Day Fund
Other articles from Anne Tergesen, Wall Street Journal
The New Rainy Day Fund: Your 401k – Transcript
We are back to talking about 401k loans and withdrawals. We’re going to be specifically talking about an article from The Wall Street Journal written by Anne Tergesen, “401k has become America’s Rainy Day Fund.”
In 2024, 4.8% of 401k account holders took early withdrawals last year for reasons including preventing foreclosure, paying medical bills. They took hardship withdrawals. They didn’t have any cash, they needed to take money from their 401k.
4.8% is a record high. It’s up from 3.6% in 2023 and the pre-pandemic average was about 2%. So it seems like more people are taking money from these retirement plans.
401k is meant to be retirement savings. You’re not allowed to touch it until age 59.5 without a penalty. Uh, just as a refresher, all of this money goes in pre-tax, and then you take it out and you have to owe tax on it.
The idea is it’s retirement savings, but if you need to tap it, there are some provisions within the rules that allows you to tap that money and take it out for specific reasons. If you don’t meet the criteria for that, then you have to pay tax on it and you have to pay a 10% early withdrawal penalty on it if you’re under 59.5.
I do think they have kind of loosened the reins a little bit in terms of what qualifies for a hardship withdrawal and the structure of taking a loan versus a hardship withdrawal. So that could speak to some of the increase in people doing this, that we’ve seen recently.
It could also be that there’s legislation out there that incentivizes employers to just auto-enroll their employees in these 401k plans. I think I see Tim shaking his head. I think that’s a huge factor in this.
People are getting auto-enrolled and they may not be ready to start socking money away for retirement. I think that’s something we’ve talked about before and it’s a multifaceted conversation because it’s, I think it’s a good thing for people to get set up for saving for retirement, but it does have some unintended consequences like what we’re seeing.
I was thinking about that when you were kind of leading us in here saying that citing pre-pandemic numbers and how much it’s risen since then. I don’t know if that’s like implying that the pandemic is causing, has caused the rise in people taking these loans and hardship withdrawals.
Part of me was thinking it just the amount of people being auto-enrolled since 2018, 1920 has just continued to go up, up and up. So like, it could just be more people being enrolled in their 401ks.
I think it’s a good thing to save for retirement, obviously, and I think the auto enrollment has good intentions and can be a good thing for people, but one of the unintended consequences could potentially be less cash flow for people in their paychecks.
But again, I think that’s also something that the individual is able to control how much money is going into the 401 case to begin with.
So, you know, there’s layers to that auto enrollment conversation and whether it’s a good or a bad thing.
The auto-enrollment feature is I think something that a lot of people haven’t even really thought through in the sense that you get auto-enrolled and every year your percentage of amount that gets saved from your paycheck and going into a 401k goes up until you reach a 10% contribution.
That used to be that you had to opt in to the plan and you had to opt in to how much you wanted to save and you had to opt in to where the money was actually going to be invested. All of that has been automated now, so overall pretty good, but there’s going to be situations where it’s not right for you.
Well, I think just a quick note on the auto enrollment in, in you have to make sure you’re auto-enrolled. I mean, I guess it depends on individual circumstances, but I remember, I think it was a Vanguard study done over the summer that we talked about that was a lot of people, if they do rollovers specifically, but it can happen if you’re just regularly contributing to 401k.
Their default investment setting was cash or a stable value fund within the 401k. I think just because it’s fair to wonder or I think ask, like, sure it’s bad that people are borrowing from their 401ks, and if they’ve been automated into it, maybe that could be improved upon in terms of the messaging and how it’s communicated.
But with the money in the 401k even exist on their balance sheet if it hadn’t been defaulted into the 401k, like it’s less than ideal that they’re having to use the money from the 401k itself. But my assumption is if it was just in their paycheck, it would have been spent.
So like, I don’t know, 401k loans better than if it didn’t exist, then it’s, what is it just credit card debt I guess or something. And I mean if they’re loosening the reins on what you can and can’t take these hardship withdrawals for, like if you’re not being penalized for taking the withdrawals and the money’s going into the 401k.
Like, is it, the number of loans and withdrawals is going up, but does that necessarily mean that it’s that bad of a thing for people like it. Are people financially worse off as a result of this?
That’s impossible to quantify except on a case by case basis. So I don’t know, it’s like, yeah, I’d love to see people get their cash flow rate and not end up borrowing against their retirement accounts, but I’m not sure what the alternative is.
We don’t get to see that world where it didn’t happen. If it is cash, it’s essentially like forced savings for them and if it happens to be going into a Target take fund or something like perhaps they even made money on that money.
So, yeah, it could end up being like not the worst thing in the world as long as they’re not paying some type of penalty or something to take the money out.
I think two things that kind of jumped out at me that a lot of people may not even be aware of is that in 2018, they eliminated the provision in 401k plans that before you apply for a hardship provision, you had to take a loan out.
Now you can just apply for a hardship provision without even taking a loan out first. I thought that was really unusual.
The second thing is starting in 2022, the IRS now created a provision that people can take a one-time $1000 distribution as a hardship withdrawal. They do have to pay that back before they can do it again, but every year they can take out up to $1000 in an emergency situation.
It really is becoming a rainy day fund.
I mean, I think just mechanically speaking too, you know, when you’re doing this, if you’re doing an early withdrawal and a hardship withdrawal, you’re not going to be, I mean you can withhold tax on it, but you can also not withhold tax on it when you take the money out and then come tax time the following year, you’ll report that as additional income.
Then if you need to owe a penalty on that, then at that point in time is when you’ll pay. You’ll either pay the tax and the penalty or just the penalty, but it’s not necessarily an immediate thing once you take the money out.
So I feel like these types of things, we always see this with like credit card delinquencies and like car loan delinquencies and it kind of is like, they use it as like a gauge to assess the viability of the consumer.
I kind of think that the name hardship withdrawals implies, you know, the percentage of people taking hardship withdrawals is increasing, so it says something about the state of the consumer and the state of the economy overall.
But in this case, I think you got to think a little more. You just gotta peel it back and look under the hood a little bit more and think things through.
Yeah, like they lowered the basket or they moved the three point line. It’s just it’s different, the circumstances kind of changed.
I mean if you change the rules to allow more people to take hardship withdrawals and then more people take hardship withdrawals, you can’t be surprised. That was the point, I guess, right?
