Survey data from 2018 indicate that people accessing 401(k) funds prior to retirement through loans or hardship distributions tend to have other debts and poor credit ratings. The tendency for people with weak household balance sheets to tap 401(k) funds prior to retirement will increase the number of people entering retirement with inadequate financial resources. This problem was likely worsened by the increased pre-retirement use of funds during the COVID pandemic.
Keywords Retirement * 401(k) * Debt
Current tax law encourages people to save for retirement by providing substantial incentives for workers to contribute to their 401(k) plans. (1) Contributions to a conventional 401(k) plan are not part of adjusted gross income in the year; they accumulate earnings and are not taxed until disbursed. Contributions to a Roth 401(k) plan are fully taxed during the contribution year, but are untaxed when disbursed after age 59 1/2.
Tax law allows workers to use funds in a 401(k) plan prior to retirement. All plan participants are allowed to cash out their entire account at any time subject to payment of tax and penalty. Plan participants can also obtain funds through a 401(k) loan or a hardship distribution. Failure to repay 401(k) loans can lead to a tax and a 10% penalty on the unpaid balance. Hardship distributions are subject to tax as ordinary income, but are not subject to a penalty.
The IRS has, in response to natural disasters, loosened restrictions on pre-retirement use of 401(k) funds. (2) The recently enacted CARES Act made even larger changes for workers experiencing economic hardship from the pandemic. The CARES Act allows workers impacted by the pandemic to withdrawal of up to $ 100,000 without penalty and to avoid tax on the distribution if funds are repaid in three years. (3)
Intuitively, the pre-retirement use of 401(k) funds will be most pronounced for people with little or no financial slack. The use of 401(k) funds prior to retirement by households with weak balance sheets will likely increase the number of households entering retirement with inadequate financial resources.
This paper uses data from a 2018 survey to provide a benchmark, pre-COVID, description of the relationship between pre-retirement use of 401(k) funds and household finances. The findings provide insight on the likelihood many households that will retire with insufficient income and wealth and the need for changes to rules governing the pre-retirement use of 401(k) assets.
2 Background on pre-retirement use of 401(k) funds
Economists are increasingly concerned about whether many households are saving enough for retirement. A recent study by Biggs and coauthors found that 401(k) balances were substantially below their potential level if workers had regularly contributed to a 401(k) account, kept funds fully invested, and earned market rates of return 4 The study identified several reasons 401(k) plans were not fully living up to their potential including the fact that 401(k) plans are a relatively new innovation, coverage for 401(k) plans is not universal, fees for many plans are high, and many people...