Earlier this month, legislation was put forward in the Senate to beef up emergency savings opportunities for retirement participants. The “Enhancing Emergency and Retirement Savings Act of 2021” would let people withdraw from their retirement accounts penalty-free.
But is that a good thing?
We’ve written on the importance of maintaining an emergency fund, and this new bill underscores that it remains top of mind not only within the personal finance niche but also by our good friends on Capitol Hill.
With Opportunity Comes Risk
The bill would allow penalty-free withdrawals from a company-sponsored 401(k) plan and your personal IRA. That’s where it gets tricky and messy from a financial planning perspective. While it’s great that folks would have yet another option to help cover unexpected bills, making it easier to tap accounts designed for long-term saving and investing might not be the greatest move.
The thing is, we are all creatures of habit and subject to a variety of biases. One of which is inertia bias–humans usually like to just stay the course when confronted with an uncomfortable decision. We prefer the path of least resistance, to put it another way.
The risk with making it easier to withdraw from long-term investing accounts, like your 401(k), is that once the money is taken out, some people fail to put it back in simply because there are headaches and paperwork involved with “paying yourself back”. Moreover, a Fidelity study found that investors save less when they have a 401(k) loan to repay.[i]
It’s a Paltry Sum
This bill is also less than ideal in that your distribution would be capped at just $1,000 each year. That’s not much if you are facing a big expense or perhaps an unfortunate job loss. Another aspect of this policy is that you’d have to pay back the initial withdrawal amount before you can do another emergency withdrawal. Just more hassle if you ask me.
The Positives
I’m not trying to be Debbie Downer on the whole topic, as there some positives to comment on. For one thing, young people might benefit from the provision since they usually have smaller account balances and less outside savings in general. Being able to tap their 401(k) without fear of penalty could be helpful.
401(k) Loans Can Be Risky
The current method of using your 401(k) for unexpected bills is known as a 401(k) loan, but not all 401(k) plans offer it and it’s often only allowed to active employees.
With a loan, you can borrow up to $50,000 or 50% (whichever is less) from your plan’s vested balance tax-free and without penalty. If your retirement account is less than $10,000, you can borrow up to the plan’s vested balance. You must repay your loan with interest back into your 401(k), generally within five years by making quarterly payments.
401(k) Hardship Withdrawals Can Be Costly
A 401(k) hardship withdrawal should be a last resort since you’ll pay income tax and a 10% penalty. So withdrawing $10,000 from your 401(k) early could result in upwards of $4,000 in taxes and penalties. Ouch! Don’t do that. If you need cash for an emergency, sit down with us at TFC to determine the best path to take so you keep more of what’s yours.
The Silver Lining On A Rainy Day
The good news is that there are a few options when you’re in a pinch and require emergency savings. A Roth IRA allows you to withdraw contributions any time tax-free and penalty-free. You can use your home’s equity for a loan or line of credit. You can also use a Health Savings Account by withdrawing up to the amount of your unreimbursed health care expenses. The best thing is to have a buffer of cash in a checking or savings account for a rainy day.
The Point
A job loss, an unexpected health event, a major accident—all of these can result in needing a lot of cash in short order. There are good options and bad options. We want to help you keep the most of what’s yours. This new legislation is perhaps a step in the right direction, but the onus is on you and me to have a safety net.
We’ll talk soon!
[i] https://loans.usnews.com/articles/the-dangers-of-401k-loans