David Lerner Associates: Early 401(k) Withdrawals: A Troubling Trend

The lingering after effects of the Great Recession are continuing to hang over the heads of many Americans like a bad hangover. Facing long periods of unemployment and stagnant wages, more Americans are now tapping into their retirement accounts just to make ends meet.

In 2010, 9.3 percent of taxpayers with retirement accounts or pensions paid penalties for taking money out of their accounts early. This number was up from 7.9 percent in 2004. And in 2011, 5.7 million tax returns reflected penalty payments for early retirement plan withdrawals.

Americans’ New Piggy Bank

The federal government now collects 37 percent more money in early-withdrawal penalties than it did in 2003 (adjusted for inflation). When you contrast this with the falling volume of home equity loans, which are now down 38 percent from their peak in 2007, it appears that retirement accounts — and 401(k) accounts, in particular — are replacing home equity loans as the piggy-bank Americans are turning to when dealing with financial distress.

This could signify a troubling trend, says David Lerner Associates Executive Vice President Martin Walcoe. “There could be serious long-term implications for Americans’ retirement prospects in the future if this trend continues,” Walcoe says. “When people take money out of their 401(k) plan early, not only are they paying a heavy price in penalties and taxes, but they’re also potentially jeopardizing their future retirement security.”

Withdrawals from a 401(k) plan that occur before the individual turns 59½ years old are generally subject to a 10 percent penalty and taxed at current ordinary income tax rates. There are a few exceptions to the penalty, such as in cases of disability and certain medical conditions and when an individual leaves his or her job at age 55 or later.

But statistics indicate that younger workers are the ones most likely to pay early withdrawal penalties. About 40 percent of workers between the ages of 20 and 39 are cashing out their 401(k) accounts when they change jobs and paying the penalty, instead of rolling the money over into their new employer’s 401(k) or an IRA.

“Often, young workers with relatively small 401(k) balances don’t think it’s a big deal to cash out and pay the penalty and taxes,” says Walcoe. “But this kind of thinking doesn’t take into consideration the fact that even small amounts of money in a 401(k) can potentially grow to much larger amounts by the time they retire many years later.”

For example, consider a 30-year-old man who takes a new job and decides to cash out the $16,000 in his 401(k), instead of rolling it over, to buy a new car. First, he will he pay $5,600 in taxes and penalties (assuming he’s in the 25 percent tax bracket), reducing his actual withdrawal to just $10,400. But he could also lose $471 per month in retirement income, assuming he retires at age 67 and earns a 4.7 percent annual return on his 401(k) investments, according to an analysis by Fidelity Investments.

Plan Loans: A Better Potential Option

For individuals who really need to tap the money in their 401(k) for a financial emergency, borrowing from their plan is often a better option than making early withdrawals, says Walcoe. “You just need to be disciplined and pay the money back to your account according to the loan terms. Otherwise, it will be considered to be an early withdrawal and taxes and penalties will be assessed.”

Many 401(k) plans allow participant loans of as much as 50 percent of the vested account balance, up to $50,000. Loans generally must be repaid within five years, unless the money is used to buy a primary residence. However, the loan usually must be repaid in full within 60 days if the individual leaves his or her job.

Material contained in this article is provided for information purposes only and is not intended to be used in connection with the evaluation of any investments offered by David Lerner Associates, Inc. This material does not constitute an offer or recommendation to buy or sell securities and should not be considered in connection with the purchase or sale of securities. Member FINRA & SIPC