How Early 401(k) Withdrawal Penalties Punish the Most Vulnerable
What You Need to Know
Recent legislative changes have eased early withdrawal penalties in some circumstances, but punishment is still the norm.
Stiff penalties for early retirement account withdrawals drive people towards alternatives such as high-interest credit card debt.
The impact of such penalties disproportionally harms the financially vulnerable.
Tapping your retirement account before the age of 59 1/2 comes at a notoriously steep cost: a penalty tax of 10% of the withdrawal amount.
The penalty is there for a good reason, in theory. These savings are precious and should only be used as a last resort prior to retirement. Money taken out early will miss the opportunity to grow tax-free and compound over time.
From the government’s point of view, 401(k)s and IRAs come with generous tax advantages and as such, you should only enjoy those benefits if you’re actually using the money for its intended purpose — providing income when you can no longer work.
But as more Americans face job losses and other financial pressures, and a record number withdraw early from their retirement savings, it’s worth asking whether the rules on withdrawals are too strict. For individuals who are in dire need of funds, why are we making it so difficult and expensive for them to use their own money? Especially when the alternative might be high-interest credit card debt.
Sure, the tax penalties for early withdrawals dissuade people from tapping their savings too soon, but if they don’t have other assets to turn to, the restrictions are just going to make their financial situation worse. Moreover, research shows such penalties might be stopping some workers from putting money toward retirement in the first place because they fear they won’t be able to access it. And the prospect of paying a penalty might prompt some savers to instead borrow against their 401(k), a move that could backfire in the event of a job loss.
Under current IRS rules, individuals can only take money out of a 401(k) without incurring a penalty in extreme situations, such as if the accountholder has become permanently disabled or has very high medical expenses and no other way to pay for them. The IRS is slightly less restrictive when it comes to IRAs, so the 10% penalty is waived for more circumstances, including certain education expenses, home purchases (up to $10,000) if you haven’t bought a home in two years and health-care premiums while unemployed.
The spending package passed by Congress late last year included a provision that allows for some more flexibility on early withdrawals from both 401(k)s and IRAs — starting next year, the 10% penalty can be waived for up to $1,000 a year for an emergency expense, for example. And victims of domestic abuse, the terminally ill or those dealing with a federal disaster can withdraw higher amounts penalty-free.
Still, those allowances don’t go far enough. First, a $1,000 withdrawal isn’t likely to be all that helpful. The cap seems to be based on the notion that any sort of easing up on penalties will lead reckless savers to drain their accounts entirely.
