Withdrawing Emergency Funds From Your Retirement Account
It is still generally a poor idea to tap into your retirement funds except in extreme circumstances. For that reason, the IRS has made it arduous to take funds out early.
This is because retirement accounts are not intended to function as a piggy bank or a savings account. Rather, their primary purpose is to help your retirement money grow with interest. Remember the power of compounding, too, which can make a significant difference when padding your nest egg.
Tough times drive more desperate measures
Over the past few years, inflation has pressured participants toward risky behaviors. When the wolf has been at the door, many have confronted the pain of the rising cost of living as they are forced to pay essential bills.
Realistically, lower-income people in particular have been turning to their 401(k) accounts for relief. Inflation in the post-COVID era has treated them cruelly.
Initially, some people might have to use savings and credit cards to cover basics, like food and rent, in dire circumstances. When those sources are exhausted, they might turn their attention to retirement accounts if they are the only lifeline to an available source of cash.
Before the pandemic, when inflation was well controlled, only 2% of participants were making hardship withdrawals. As inflation took hold, according to Vanguard data, 2.8% were raiding their accounts in 2022 — a value that further increased to 3.6% by 2023.
The average annual hardship distribution increased from $5,500 in 2021 to $7,000 in 2023. According to Alight Solutions, a 401(k) provider for large plans, approximately 50% use hardship withdrawals to avoid eviction or foreclosure. An estimated 15% pull from retirement to pay for medical bills, and 10% do so for college tuition.
On the other hand, Vanguard data also indicates resiliency among 96% of 401(k) holders whose balances actually rose 19% in 2023. But why?
Well, the roaring bull market was likely largely responsible since the S&P itself rose by 24% during that banner year. If the averages should return to the mean, that tailwind might lose force.
SECURE Act eases some penalties
Before the act took effect in December 2022, a penalty of 10% was imposed upon those who removed funds before turning age 59½. This existed as yet another formidable deterrent.
Sure, some hardship exceptions apply to early redemptions, but the rules are strict. Participants can only remove the amount of money required to alleviate the hardship, and it must be approved by plan administrators.
Acceptable hardships include:
- Medical care incurred by plan holders, spouses, or dependents
- Principal residence costs, excluding mortgage payments
- Educational expenses
- Eviction prevention
- Home damage due to fires, earthquakes or floods
- Funeral costs
Under the new rules, the burden is slightly lighter. Now participants can withdraw up to $1,000 for emergencies like medical crises, car repairs or funerals.
The money must be repaid within three years, though, and the account balance cannot sink below $1,000. Employers can choose whether to allow these withdrawals, so some may not agree even if conditions of the plans are met.
Other new breaks involve disabilities, though disability claimants cannot engage in any moneymaking activity whatsoever. Furthermore, people who were victims of domestic abuse within the past year can take out $10,000 or 50% of the account holdings. Plus, inhabitants of federally declared disaster areas are entitled to withdraw $22,000.
A last resort
No matter your situation, the principle still applies: Do not venture into a retirement account without significant justification.
For instance, never treat your retirement account as a source of cash for optional disbursements, especially not a vacation or a new car. Likewise, do not consider dipping into your account to remodel your kitchen or bathroom.
Make sure you have exhausted the gamut of other possible options. Aside from emergency rainy-day savings, have you considered leaning on friends and family for assistance? What about applying for a home equity loan?
Banks and credit unions may be the preferred answer if that money can go to any purpose. That said, in very dire situations, filing for bankruptcy is sometimes a better alternative to paying off creditors than raiding your 401(k).
However, keep in mind that this is just an overview. Additional provisions will apply, and there are other fine points. Also, rules may change with little notice.
The bottom line? Work with your financial adviser to craft a viable way forward. That way, you can continue to shield your precious retirement resources no matter what life throws your way.
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