Last year, a record number of Americans tapped their 401(k) accounts for so-called hardship withdrawals, a financial lifeline that can help those who are financially stressed deal with situations such as medical care or avoiding eviction.
According to the financial services company Fidelity, the proportion of 401(k) participants making hardship withdrawals increased to 2.4% in 2018 from 1.9% in 2021. This is the highest percentage of hardship withdrawals ever recorded by Fidelity, which highlighted that the percentage generally varies between 2% and 2.3% annually.
The increase in hardship withdrawals follows a year with the biggest inflation in four decades and rising interest rates, both of which have made it more expensive to borrow money and purchase a variety of commodities. Mike Shamrell, vice president of thought leadership, workplace investing, at Fidelity, remarked that hardship withdrawals are only authorized under a limited set of circumstances indicating severe financial difficulties.
“They are congested; they are in a gridlock. This is not something to be taken lightly “he said. “Hardships aren’t meant for if your daughter gets engaged and you have to set aside money for their wedding.”
What is “hardship”
The IRS permits hardship withdrawals under a restricted set of circumstances, such as medical treatment, tuition for the worker or their family, payments to avoid eviction or foreclosure, burial expenditures, and spending to repair damage to the employee’s primary dwelling.
The tax agency notes that consumer purchases, such as buying a car or a boat, are not seen as an immediate and substantial financial need and hence would not be authorized.
Shamrell stated that the nation’s economic headwinds may not be the major reason for the increase in hardship handouts due to the fact that they are tied to situations such as a funeral or property damage. In recent years, IRS regulations have made it easier for Americans to take a hardship withdrawal, such as a 2018 regulatory modification that let workers to withdraw both their personal contributions and the monies given by their employer as a corporate match.
The Secure 2.0 retirement regulations signed into law by President Biden in December 2023 may make hardship withdrawals even more accessible in 2023. The new regulations permit employees to self-certify that they meet the hardship criterion and would only withdraw the minimum amount necessary to cover their financial emergency. Previously, employees were required to demonstrate their eligibility to their employer or plan sponsor.
When cash withdrawals make sense
Shamwell added that while retirement advisers generally advise employees to avoid borrowing from their 401(k)s, hardship withdrawals make sense if the alternative is catastrophic, such as being evicted from your home.
They are not borrowing against future earnings or taking out a 401(k) loan or a payday loan, he explained. “The last thing we want to make them do is feel even worse about tapping their 401(k) when they are in an emergency situation.”
Fidelity discovered that although more workers are using their retirement funds, they are withdrawing lower amounts. In the first quarter of 2021, the average 401(k) hardship withdrawal was $3,900, but this decreased to $2,200 in the fourth quarter of 2022.
“People are only taking what they need, so that’s a positive,” said Shamwell.
Tips for saving more in 2023 despite increased living expenses and inflation
It is crucial to know that there are penalties for withdrawing from your 401(k) (k). Workers younger than 59 1/2 are subject to a 10% early withdrawal penalty, and their withdrawals are taxed as regular income (for taxpayers of all ages). In contrast to 401(k) loans, which must be repaid within a few years, employees are not required to repay the hardship withdrawal.
Fidelity observed that since the beginning of the pandemic, the proportion of workers taking out 401(k) loans has declined. 401(k) loans are when people borrow money from their accounts but must repay it. Fidelity said that slightly under 17% of retirement plan participants had outstanding loans in the third quarter of 2022, down two percentage points from two years prior.
“People are becoming much more aware of the fact that their 401(k) is not something that should be viewed as a way to cover expenses, that they might want to cover that from other sources,” Shamwell said.
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