Did you know millions of Americans are dipping into their retirement accounts prematurely, causing permanent damage to future retirement account balances?
According to a new study released by the Center for Retirement Research at Boston College (CRR), 1.2 percent of all assets leak out annually, mostly from cash-outs (0.5 percent) and hardship withdrawals (0.3 percent).
The ability for American workers to tap retirement accounts can ultimately reduce the value of 401(k) and IRA accounts by 25 percent – undermining retirement security.
Sources of Leakage
A medical emergency, job lay off or other family emergencies can force participants to withdraw money from their retirement accounts – causing leakage.
In addition to losing the benefit of long-term, tax-deferred growth, workers face substantial penalties and taxes on early withdrawals.
According to CRR, there are three sources of retirement savings leakage:
In-service withdrawals: Withdrawals come in two forms: hardship withdrawals and withdrawals after 59 1/2. “Hardship” is defined as an “immediate and heavy financial need,” including medical costs, education expenses, purchase/repair of a primary home, as well as avoiding foreclosure. Hardship withdrawals are subject to income tax and a 10 percent withdrawal penalty. After age 59 1/2, withdrawals can be made penalty-free.
Cash-outs: When workers leave an employer, there are three choices employees can do with their retirement assets: They can leave the funds in the employer’s plan, roll over the balance into an IRA or into a new employers 401(k), or take a lump-sum distribution. The third option is what causes the majority of leakage, according othe CRR study. “Taking a lump sum distribution not only gets you less money than you’d thought due to taxes and penalties, but deals a permanent setback to your retirement planning once it is withdrawn. In addition to losing the benefit of long-term compounding and tax-deferred growth, workers face substantial penalties and taxes on early withdrawals,” says Greg McBride, chief financial analyst with Bankrate.com.
Loans: Some qualified retirement plans include the option for participants to take a loan against their retirement account balance. Unlike a withdrawal, a loan is treated as part of your portfolio and must be repaid to the plan in order to avoid tax consequences. However, if the loan isn’t repaid in full, the balance of the loan is treated as a lump-sum distribution and is subject to both income tax and a 10 percent penalty tax.
Under existing rules, 401(k) participants can borrow up to half of their account balance but not more than $50,000.
“Whether you leave the job, or are told to leave, any unpaid loan balances are treated like a distribution and are subject to taxes and penalty. You’ll never be able to replace that withdrawn money in future years,” says McBride.
Repairing Leaky Retirement Accounts
Whether by choice or necessity, financial experts agree that when you take money out of your retirement account you lose the power of compounding interest.
To maximize retirement resources, it’s vital to save generously and limit pre-retirement access to your savings so that every dollar stays invested for retirement. If you tap your savings today, it won’t be there tomorrow.
But as McBride points out, “it’s rarely anyone’s intention to raid the retirement account, but you never know what life will throw at you. Even people with adequate emergency savings can see that wiped out during a financial hardship, forcing them to use their retirement account as a backstop.”
CRR issued recommendations that sponsors should consider as ways to slow, if not prevent, leakage. Among them:
- Raise the age requirement for early withdrawal from 59 ½ to 62 to match the earliest Social Security retirement age.
- Tighten hardship rules even more and only allow hardships in case of “unpredictable events,” for both 401(k) plans and IRAs.
- Remove cash-outs altogether.
The study concludes that “applying these principles to restructuring access to retirement savings could boost retirement assets for workers at a time when more money is needed for a secure retirement.”
Which of the CRR recommendations do you think would have the biggest impact on preventing leakage from retirement accounts?
Ally Wallet Wise
It’s never too early or late to begin planning for retirement. During the week of April 13-17, 2015, learn more about retirement saving, planning and managing your assets in retirement by visiting the National Retirement Planning Coalition. To brush up on the basics of money management and to improve your overall financial knowledge and habits, visit Ally Wallet Wise where you can download a monthly budgeting worksheet, take online courses or test your financial IQ.