Hardship 401(k) Withdrawals Portend More Hardship Ahead

Your retirement savings are meant to stay in your 401(k) until you are well into retirement. Increasingly, that hasn't been the case for many Americans.

In the third quarter, 2.3% of workers took a hardship withdrawal from their retirement savings, according to recent data from Fidelity Investments. That's up from 1.8% during the same quarter last year.

While the increase may seem small, it's reflective of an overall upward trend seen in yearly data: In 2007, only 1.2% of workers took hardship withdrawals from their 401(k)s, but as of October, Fidelity reports that that number is as high as 6.4% for 2023.

Depleting your retirement savings can come with significant consequences, especially as health care costs continue to rise, corporate pensions go by the wayside and people are living longer.

Experts say that the fact that more people are tapping their retirement savings is worrisome for the bigger economic picture of the future of retirement, as well as for individual savers.

"Some of these decisions have lifetime consequences," says Josh Hodges, chief customer officer at the National Council on Aging (NCOA).

Not just any early withdrawal from a 401(k) is considered a hardship withdrawal. In order to take a hardship withdrawal, a saver must have "an immediate and heavy financial need" that qualifies them for the withdrawal under very specific guidance outlined by the IRS.

The agency considers certain medical expenses, funeral expenses, tuition and payments needed to prevent eviction and foreclosure to be among those that qualify someone for a hardship withdrawal.

The top two reasons behind the recent uptick in hardship withdrawals were people removing money to avoid foreclosure or eviction, and to cover medical expenses, according to the Fidelity data. A hardship withdrawal is often a last resort, says Michael Shamrell, vice president of thought leadership at Fidelity.

"If you qualify for a hardship [withdrawal], you're already in a financial jam," he adds.

But savers aren't only turning to hardship withdrawals. In the third quarter, 2.8% of participants borrowed from their 401(k), up from 2.4% in the same quarter in 2022. And 3.2% of participants took an in-service withdrawal, up from 2.7% a year ago. An in-service withdrawal takes place while someone is still employed at the company where they have an active retirement savings account, and that typically comes with a 10% penalty.

Taking a hardship withdrawal isn't an option that's always available since plan sponsors aren't required to provide for hardship distributions. But if hardship withdrawals are allowed, they come with consequences: You'll have to pay income taxes on the withdrawal come Tax Day, and you may have to pay a 10% tax penalty. (There are some exceptions to the 10% penalty rule, including for participants with a disability or terminal illness.)

Plus, while the average Fidelity 401(k) balances decreased 4% in the third quarter from the quarter before amid poor performance from the stock and bond markets, pulling money from your account in a market slump means missing out on an imminent recovery or the long-term potential for high returns that investing in financial markets provides.

A $10,000 investment in the S&P 500 on January 1, 2003, would have grown to nearly $69,000 by December 30, 2022 — but if it missed the 10 best days of the market, that return would have been cut in more than half, according to J.P. Morgan Asset Management's Guide to Retirement report.

"The power of savings comes from the power of compounding interest," says Teresa Ghilarducci, director of the Schwartz Center for Economic Policy Analysis at The New School for Social Research.

Fidelity illustrated this phenomenon in its report by noting the 11% increase in average 401(k) balances from a year ago and a 27% increase from 10 years.

Overall, yanking your money out of a retirement savings account early means you'll have less money for your retirement — a phase of life during which many people are already struggling to get by.

Of people aged 60 and older, 80% do not have the financial resources to cover long-term care services or a financial shock, according to a report NCOA published earlier this year.

Taking money early from a 401(k) can foretell an impoverished retirement for those who do it — and lower- and middle-income Americans are impacted the most, Ghilarducci says.

But sometimes, taking hardship withdrawal is better than the alternative, says Anqi Chen, senior research economist and the assistant director of savings research at the Center for Retirement Research at Boston College. Doing so likely costs someone less than running up high-interest credit-card debt or subprime bank loans.

In fact, the biggest concern around the uptick in hardship withdrawals is why people are taking hardship withdrawals, Chen says.

"Why do people face crippling medical debt? Why are people facing evictions and why are people facing foreclosures?" she asks. "It's concerning in the broader economic context, the fact that people are facing these hardships."

That may not be something the retirement industry can reckon with on its own. But as costs continue to rise and Social Security's trust fund continues to decline, the reason behind hardship withdrawals is as much as — if not more of — a concern than the withdrawals themselves, some experts say.

Fidelity's report didn't only have bad news. The data shows that people continued to regularly contribute to their 401(k)s despite high inflation.

The total savings rate for the third quarter — including a combination of employee and employer 401(k) contributions — was 13.9%, which is in line from the second quarter and slightly up from a year ago.

"We're encouraged," Shamrell says of the consistent savings rate despite the uptick in hardship withdrawals.