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Preretirement 401(k) breaches on the rise

Well over half of U.S. employers use 401(k)s and other defined contribution plans to encourage their employees to save for retirement, collectively spending more than $118 billion in match contributions and encouraging employees to save another $175 billion every year, according to a January 2013 report, "The Retirement Breach in Defined Contribution Plans: Size, Causes and Solutions."

Yet, more than 25% of households that use a defined contribution plan for retirement savings have withdrawn, or breached, some or all of their plan balance for nonretirement spending needs, amounting to more than $70 billion withdrawn in 2010, the most recent year for which the relevant Federal Reserve and IRS data were available, according to the report by financial advisory firm HelloWallet.

Of that breached $70 billion, nearly $60 billion was subject to income taxes and IRS early-withdrawal penalties, while the other $10 billion included new loan originations that risk being taxed and penalized if not eventually repaid.

In general, when employees take a distribution from a traditional 401(k) or other non-Roth defined contribution plan before age 59½, they are subject to a 10% penalty, in addition to owing income taxes on the amount withdrawn (see “Loans vs. Hardship Withdrawals” below).

Moreover, the value of penalized breaches has increased over time, growing from about $36 billion in 2004 to nearly $60 billion in 2010, according to the report, which also noted that:

  • Workers in their 40s were most likely to breach their savings for nonretirement needs. By the time workers hit their 40s they are highly likely to be burdened with mortgages and revolving credit card debt and have children in high school or on their way to college, creating the largest pressure to breach among any age group.
  • More than 70% said they breached their account because of basic money-management problems. Similarly, workers were up to six times more likely to have taken out a loan from their plan if they did not have sufficient emergency savings, while fewer than 8 percent of breachers said they took early distributions because they had been laid off.

Stemming the breach

“The evidence provides guidance about how plans can proactively take steps to reduce breaching in their population,” the report concludes. “As a basic first step, helping workers better manage their finances by reducing the prevalence of spending more than they make and to meet their monthly recurring expenses could reduce the prevalence of breaching.”

In addition, “Encouraging workers to save for emergencies prior to using their retirement savings program would potentially reduce the need to breach and both strengthen the integrity of a retirement plan and the sustainability of its assets over a worker's lifetime.”

Nevertheless, the report advises against further prohibiting distribution options for participants. “Nearly all households that breach are financially unhealthy even after they receive distributions from their retirement savings,” the authors note. Prohibiting access to retirement funds, in these cases, would “exacerbate the basic money-management problems that are strongly associated with breaching in the first place.”

Loans vs. hardship withdrawals

401(k) plans may (but are not required to) allow participants to take loans or make hardship withdrawals.

Loans must be paid back over five years, although this can be extended for a home purchase. While loan interest rates vary by plan, the rate most often used is the “prime rate” plus 1 or 2 percentage points. Interest is paid back into the participant's 401(k) account. If not repaid within five years, the loan amount is treated as a distribution, and if participants are not at least 59½ years old, they must pay a 10% penalty on top of income taxes on the withdrawn funds.

Hardship withdrawals are subject to certain IRS restrictions. The withdrawn amount is subject to income tax and, if participants are not at least 59½ years old, the 10% withdrawal penalty, unless certain exceptions apply. Participants do not pay back the withdrawn amount, which means their ultimate retirement savings will be much more seriously affected.

Stephen Miller, CEBS, is an online editor/manager for SHRM.

©2013 SHRM. All rights reserved.

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