I’m generally a huge proponent of 401(k) plans, urging people to fund them as much as possible to avoid a financially shaky retirement. (My Next Avenue colleague, Larry Carlat, calls me the scariest man he knows because my blog posts are often filled with warnings. Larry: Did you see the new AARP study that found middle-class workers age 45 to 64 saw their overall financial security plummet 32 percent between 2004 and 2010?)
But I’m now starting to think too many of the 51 million Americans who are investing in 401(k) plans shouldn’t be. Maybe you’re one of them.
How Employees Drain Their 401(k)s
The problem is that, according to just-released research from HelloWallet, a financial advisory firm based in Washington, D.C., a large and growing number of employees — one in four 401(k) participants — are breaking into their retirement accounts to use the money for financial emergencies and other purposes.
(MORE: Watch Out: Your 401(k) Is Being Targeted)
They’re making hardship withdrawals, cashing out of their plans entirely when leaving their jobs and taking out 401(k) loans. Employees are tapping these funds typically to douse the flames when an unexpected emergency has set their finances on fire. As a result, they could be putting their financial future at risk.
In retirement parlance, each of these moves is known as a 401(k) breach.
More than 25 percent of employees using 401(k) plans have taken money out of them for “non-retirement spending needs” — amounting to more than $70 billion in annual withdrawals, the study says. (I’m a little suspect of that $70 billion figure, but the trend is undeniable.)
The Employee Benefit Research Institute says 21 percent of all 401(k) participants eligible for loans took one in 2011, up from 18 percent in 2008. (The average unpaid balance: $7,027.) And an Aon Hewitt study found that roughly one-third of employees in their 50s and 60s with 401(k)s cash out of the plans when they change jobs.
Midlife Employees Tap Plans the Most
Workers between age 40 and 59 are the ones most likely to tap their 401(k)s through withdrawals, cash outs and loans, according to HelloWallet.
(MORE: Is Borrowing From Your 401(k) a Good Idea?)
“They have the most intense financial pressures, with mortgages, credit card debt and maybe kids in college,” says Matt Fellowes, founder and chief executive of HelloWallet. “When they run into unexpected expenses, it’s a big shock to their financial system. You can roll with the punches when you’re in your 20s or 30s. But by the time you’re in your 40s or 50s, there’s not a lot of room for error.”
It isn’t that 401(k) breachers are looking at their retirement plans as piñatas they can empty at will.
The Root Cause of Breaking Into 401(k)s
The problem, Fellowes says, is that many have failed to create emergency savings funds outside of work, so they resort to their retirement plans to handle life’s unforeseen blows.
“If a household lacks emergency savings, they have twice the probability of breaching their balances, compared to households that have sufficient emergency savings,” the HelloWallet study says.
Workers are up to six times more likely to take out a loan against their plan balance if they lack emergency savings. “But if people build up emergency savings effectively and budget their money, the need to take out 401(k) loans will be substantially reduced,” Fellowes says.
Not surprisingly, lower-income employees are the most likely to pull money out of their 401(k)s, since they’re the ones in greatest danger of needing cash for an emergency.
Workers in households earning less than $50,000 a year have a 35 percent chance of using all or some of their 401(k) balance for something other than retirement; just 12 percent of households earning more than $150,000 will breach.
Taking money from your 401(k) as a hardship withdrawal (examples: unreimbursed medical expenses, the purchase of a home or college tuition) or cashing out entirely can be an expensive proposition, since you’ll often owe income taxes and a 10 percent penalty on the money if you’re under 59½. (The penalty is waived in a few circumstances, such as if your medical expenses exceed 7.5 percent of your income or you leave your employer at age 55 or older.)
How $50,000 Becomes $32,500
Abram Brown of Forbes notes that a 55-year-old employed man who wanted to withdraw $50,000 from his 401(k) would get to keep only $32,500 because $17,500 would go to taxes and the early-withdrawal penalty.
To me, the dangers and drawbacks of cracking into your 401(k) — either through a hardship withdrawal, cashing out or taking a loan — mean that you need to fill up an emergency savings fund before you start contributing to your retirement plan.
In a strange way, the 401(k)-tapping phenomenon is an unintended consequence of the trend toward automatic enrollment in the plans, designed to get more workers to save for retirement. With automatic enrollment, money is regularly taken out of your paycheck and put into the firm’s 401(k) unless you specifically choose to opt out.
(MORE: Investment Fees: Are You Getting Ripped Off?)
But some who’ve auto-enrolled would’ve helped their financial situation by staying out of the plans and funneling the money into a rainy day fund that they could withdraw from without owing a penalty. “They’d be better off with short-term savings vehicles,” such as safe, no-cost money market bank accounts, Fellowes says.
How Employers Can Help Workers
Fellowes thinks it’s time more employers help route employees to appropriate savings choices, rather than push everyone into 401(k)s, through smarter, more personalized automation. “We need to automate compensation packages to be more aligned with the needs of individuals,” he says. “That will save companies money and help employees with their financial well-being.”
To some extent, his advice is self-serving; firms like Heinz and Marsh & McClennan, a risk-management consultant, provide employees with HelloWallet’s advice to help them budget better, save for emergencies and achieve their financial goals. (You can also sign up for HelloWallet’s service on your own and get personalized financial advice on saving and spending for $8.95 a month or $89.95 a year.)
Chances are, more firms will set up automatic payroll deduction programs for emergency savings.
Doing so would reduce their costs, since they’d no longer pay investment companies to manage 401(k) accounts for employees who shouldn’t be in them, what Fellowes calls “a fairly flagrant example of wasted spending by employers.”
Will Washington Clamp Down?
Incidentally, although Congress and the Obama administration seem to be targeting the tax breaks of 401(k)s as a way to generate revenue, as I wrote recently, Fellowes doesn’t expect Washington to stiffen withdrawal rules for the plans anytime soon.
“The retirement crowd in town is focused on the fiscal cliff,” he says. “But they know this is a growing problem.”
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