Early 401k Withdrawals Thwart Long-Term Goals

RISMEDIA, October 1, 2009—(MCT)—A forthcoming federal report on retirement savings recommends easing a penalty for hardship withdrawals from 401(k) plans and that workers receive better education about the consequences of such decisions.

The Government Accountability Office (GAO) report suggests ways for Congress and federal agencies to reduce the long-term impact of early withdrawals, or “leakage,” from retirement plans. The economic downturn has caused many 401(k) participants to take drastic measures with their retirement accounts. About one in seven cashes out of a plan after a job change or loss (without rolling over the money to a new account), take hardship withdrawals, or borrow against their portfolio, according to the GAO report. “Even small amounts of leakage can have a significant impact on the retirement savings of some plan participants,” the GAO said.

Some Washington lawmakers are concerned that by tapping 401(k) funds for immediate needs, workers are jeopardizing their long-term retirement security.

“Americans’ retirement savings have taken a huge hit due to the recession,” said Sen. Herb Kohl, D-Wis., chairman of the Senate’s Special Committee on Aging, in a written statement. “Despite the financial hardships many are facing, people need to resist raiding their 401(k) because it’s a really bad deal for them over the long run.”

The GAO study says Congress should consider changing a rule that prohibits 401(k) participants from making additional contributions for six months after a hardship withdrawal. The suspension also includes employer matches. The requirement, the GAO report said, may in fact make the leakage problem worse “by barring otherwise able participants from contributing to their accounts.” In addition, the GAO said the Labor Department should encourage employers to give workers “understandable and useful information” about the adverse long-term consequences from hardship withdrawals, loans and cash-outs. Also, participants could view projections of their account balances when left in a tax-deferred portfolio versus the results if they cashed out. The GAO also said the Treasury Department should clarify 401(k) regulations that require participants to exhaust all available loans before resorting to hardship withdrawals that subject workers to taxes and early-withdrawal penalties.

“Participants facing sudden and anticipated hardships would also benefit from the assurance that they are using the most appropriate and least damaging option,” the report said, “thereby minimizing the negative impacts on their overall retirement preparedness.”

The year-long study, completed in August 2009, was commissioned by the Special Committee on Aging. The report takes particular aim at cash-outs, noting it can be “the most damaging form of 401(k) leakage,” is the least regulated, and runs “counter to the goal of retirement savings.” (In a cash-out, the money is not rolled over to another retirement account). Cash-outs of any amount—partially or in full—can impact a participant’s account balance at age 65 more than comparable amounts taken either in a hardship withdrawal or a loan, the GAO said.

“Participants who voluntarily cashed out their entire 401(k) account balance at job separation experienced the largest reductions in the amount of retirement savings that accumulate over their working careers,” the report noted. For example, a participant who cashed out his entire 401(k) at age 35 would forfeit more than $183,000 in savings by his 65th birthday, according to the report. Cashing out later in a career, when there is less time to recover from losses, leaves an even bigger wealth gap. Yet many participants choose to cash out of a plan when they leave a job, in part because they aren’t given enough information about the potential hit to their finances, the GAO said.

The report noted: “With better information on the consequences of the various forms of leakage, participants may choose to preserve their retirement savings, resulting in a better retirement outcome.”