Thanks to new legislation, Americans with retirement plans now have easier access to cash in the event of a financial emergency. A provision in the Secure Act 2.0 that took effect this year allows individuals with 401(k)s and other retirement plans to withdraw up to $1,000 without triggering a 10% early distribution penalty.
The change will give workers a little more breathing room should they confront a job loss, a sudden car repair or any other unforeseen event. Importantly, access to the funds could help spare people from having to use credit cards with devastatingly high interest rates when the unexpected arises.
But $1,000 isn’t much for many people in the throes of a financial emergency. Consider that 26% of registered voters don’t have any readily available savings at all, according to a recent survey by BlackRock. Also, the $1,000 withdrawals will be subject to ordinary income tax if they aren’t repaid in three years, potentially eroding what is already a small sum to cover an unplanned expense.
Congress took an important first step when it passed the law allowing penalty-free withdrawals for effectively any reason. But lawmakers should have gone further and raised the cap to a more useful level of $3,500 and paired it with modest annual increases tied to inflation.
In an ideal world, no one would need to use their retirement funds for anything other than their intended purpose. But that’s just not the reality in which most Americans live. Some 41% of people 18–34, a group that includes younger millennials and Gen Z, don’t have any emergency savings at all, according to the BlackRock survey.
But every age group is vulnerable. Gen X, often dubbed the sandwich generation because of the need to care for aging parents and children simultaneously, carries the highest debt levels of any cohort, according to an analysis of Credit Karma member data. Gen X is also the generation most likely to have an outstanding 401(k) loan. Nearly a quarter of Gen X workers owe on one, compared with around 18% of workers overall, according to Fidelity.
People don’t age out of financial stress. It merely changes shape.
One benefit to allowing a retirement account to function as an emergency backstop: It’s likely to make contributing to a retirement account more attractive for people who are worried about allocating their limited funds to multiple priorities.
While workers have long been able to take out funds in excess of $1,000 from 401(k) plans under certain circumstances, they generally have had to prove that they were facing a genuine financial hardship or use the funds for a down payment on a home or for education expenses. The new rules allow employees to self-certify that they have a pressing need, provided their employers allow pre-retirement withdrawals in the first place.
When Congress adopted the new rules, lawmakers established guardrails to prevent people from relying too heavily on their retirement nest egg, including limiting distributions to one per year and requiring account holders to repay the withdrawal within three years or owe ordinary income tax on the sum.
Those limits are smart. As much as I believe that savers should be able to withdraw modest sums from retirement accounts, there is a danger that people will start to view their 401(k) as a fund that can be regularly tapped to cover unexpected expenses.
Indeed, if the withdrawal cap were to be raised to $3,500, I would add a few more restrictions. Savers should be eligible to withdraw only from their own contributions and not from vested employer contributions. To offset the potential drain on their savings, account holders also should be required to continue contributing to their 401(k) at a minimum of 3% of their annual pay until the distribution is repaid. An individual earning $80,000 who contributed 3% of their salary would be able to repay the $3,500 distribution in less than two years.
While $1,000 or even $3,500 seem like small amounts to withdraw, the “missing” funds will be felt over time. Investing $1,000 for 30 years with an average 8% return will yield just over $10,000; investing $3,500 would yield around $35,200. Taking a $3,500 distribution year after year could cost future retirees hundreds of thousands of dollars in lost income, which is why it’s important to require repayment and set limits around access.
Digging into retirement funds during one’s prime working years is less than ideal, but the consequences of racking up credit card debt — or forgoing important expenses such as child care or next month’s rent payment — can be much worse. It’s easy to forget that paying off high-interest credit card debt often takes years and siphons away money that could have been routed toward savings and retirement.
The entire point of the Secure Act 2.0 is to bolster retirement savings and increase people’s confidence in their ability to live a comfortable life after leaving the workforce. But we can’t ignore that the unexpected happens and that sometimes, prioritizing the needs right in front of us is the best decision we can make.
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