Americans are tapping into their retirement savings early. The dos and don'ts of 'hardship withdrawals'

More Americans are tapping into their 401(k) to make ends meet — treating it more like an emergency fund than a retirement savings plan.

Hardship withdrawals are running 15% to 20% above the historical norm, Empower CEO Ed Murphy told Bloomberg TV. Empower is the second-largest retirement plan (by number of participants) in the U.S.

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While new rules make it easier to withdraw funds, some people may be turning to their retirement savings as prices on consumer goods — from groceries to cars — tick upward.

“There is a corollary to what you are seeing in the U.S. economy with deferred payments on auto loans and mortgages,” Murphy told Bloomberg TV. “So that’s something we monitor carefully.”

What’s a hardship withdrawal?

Hardship withdrawal rules for 401(k)s changed in 2024, in accordance with the Securing a Strong Retirement Act of 2022 (SECURE 2.0).

A hardship withdrawal allows you to withdraw money from your 401(k) to cover an “immediate and heavy financial need,” according to the Internal Revenue Service (IRS).

Some people may be making this decision based on financial hardship, such as housing or medical debt.

A new report from Vanguard noted similar findings to Empower, with 4.8% of 401(k) participants initiating a hardship withdrawal in 2024 — up from 3.6% in 2023.

While there are a few “signals of a possible uptick in financial stress,” the report says that for some workers hardship withdrawals “may serve as a safety net that otherwise may not have been available without plan-implemented automatic solutions.”

Another report, this one from the Transamerica Center for Retirement Studies, found that more than eight in 10 (83%) of employed workers are saving for retirement.

However, 37% say they’ve already tapped into their retirement accounts, “including 31% who have taken a loan and 21% who have taken an early and/or hardship withdrawal,” according to the report.

“Today’s workers are stuck between a rock and a hard place,” said Catherine Collinson, CEO and president of Transamerica Institute and TCRS, in a release. “They are traversing disruptions in the economy, a tenuous employment market, and the high cost of everyday living — while being expected to self-fund a greater portion of their retirement income compared with prior generations.”

Add to that the possibility of heading into a recession — with consumer confidence plummeting — and more Americans may find themselves struggling to pay the bills.

“We encourage people to have an emergency savings account, have at least two years of expenses set aside in the event these types of situations occur,” Murphy told Bloomberg TV.

Even the IRS is prepared for an increase in hardship withdrawals, stating on its website that “given the current economic climate, a greater number of participants may be requesting hardship distributions from their retirement plans.”

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What are the consequences of tapping into your 401(k)?

The amount you’re allowed to withdraw is limited to the amount necessary to “satisfy that financial need,” according to the IRS. However, if you’re under age 59½, your withdrawal could come with a 10% early withdrawal penalty.

You may be able to avoid this penalty if you meet the IRS’s eligibility for safe harbor distributions, such as the pending foreclosure of your home. But it won’t get you out of paying taxes.

The money you withdraw from your 401(k) is taxable income, which could potentially bump you into a higher tax bracket. If you’re not sure how this could impact your tax bill, it could be worth chatting with a financial advisor.

There are also longer-term consequences, such as the loss of compounding growth, which could significantly hinder your retirement goals. That’s why a hardship withdrawal is usually considered a last resort.

If you’ve already eaten through your emergency fund, there are still some options you could consider before a hardship withdrawal. For example, you may be able to withdraw from other retirement accounts.

A Roth IRA, where you’ve already paid tax on your contributions, may be a preferable option since you won’t be taxed on withdrawals — though you’ll still have to pay an early-withdrawal penalty if you’re under age 59½.

You could also take out a 401(k) loan (versus a hardship withdrawal). That means you pay the money back, but the interest on the loan goes into your account. Check with your HR manager to see if this is an option, since not all plans offer it.

You could also look for ways to reduce expenses (like cancelling an upcoming vacation or selling a second vehicle) or earning extra money (such as taking on extra shifts at work or renting out a room in your home).

If you’ve exhausted all other options and decide to make a hardship withdrawal, it’s worth consulting a financial advisor as well as your plan advisor so you fully understand how it will impact you now and in your golden years.

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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.