401(k) Hardship Withdrawals Just Reached an All-Time High

The purpose of saving for retirement in an IRA or 401(k) plan is to have money during your senior years. Many people who retire leave the workforce for good and opt not to hold down a part-time job. In that scenario, you’ll need income to supplement your Social Security benefits.

That’s a big reason the IRS tries to incentivize workers to sock money away in an IRA or 401(k) plan via tax breaks. It wants people saving for retirement, and just as importantly, it wants savers to leave their nest eggs alone until their senior years arrive.

But new data from Vanguard reveals that a growing number of savers are tapping their retirement savings prematurely. And that means they risk falling short on money later in life.

A disturbing trend

Some 401(k) plans allow savers to take what’s known as hardship withdrawals, which are needed to address an immediate financial need. And Vanguard reports that the number of hardship withdrawals reached an all-time high this past October.

Why the uptick in hardship withdrawals? It’s fair to point a finger at inflation.

Since the second half of 2021, living costs have gone nowhere but up. Whereas lawmakers were generous with stimulus aid in 2020 and 2021, this year, there’s been no federal stimulus payday to help workers boost their income. The combination of absent aid and inflation could be a big driver of 401(k) hardship withdrawals this year.

Rising borrowing costs may be playing a role, too. The Federal Reserve has been steadily raising interest rates this year in an effort to slow the pace of inflation. That’s made consumer borrowing more expensive. So 401(k) savers may be more inclined to simply tap their own cash reserves to address a need for money rather than face sky-high interest rates on personal or home equity loans.

A cycle worth breaking

It’s easy to see why savers have been more inclined to take hardship withdrawals from their retirement accounts. But that’s far from a positive trend.

Although many 401(k) plans allow for hardship withdrawals, savers who take advantage of them face taxes on the money they remove, plus a very costly 10% early-withdrawal penalty. In fact, it’s a big myth that the penalty is waived for hardship withdrawals. Often, that’s not the case.

But perhaps an even bigger issue is that those who remove funds from their retirement savings during their working years risk falling short on income later in life. This is an especially large concern these days, given the potential for Social Security cuts down the line.

As such, savers should really do everything they can to avoid raiding their nest eggs before they’re supposed to. In fact, everyone, regardless of age, should have an emergency fund with enough money to cover multiple months’ worth of essential bills. Boosting emergency savings might help some people avoid having to tap their long-term savings when life throws them a financial challenge they need help recovering from.

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