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Despite damage it can do, tapping 401(k)s early is common

Most 401(k) withdrawals are for everyday expenses, not hardships such as medical emergencies.

Johns Hopkins Medicine via AFP/Getty Images

Most 401(k) withdrawals are for everyday expenses, not hardships such as medical emergencies.

Early withdrawals from 401(k) and 403(b) retirement accounts can have significant effects on a nest egg. Even borrowing against those accounts can stunt their growth. Yet a study shows that more than one out of four households dip into such accounts — sometimes emptying them out.

The study, by HelloWallet, offers an unorthodox prescription for some employees with financial problems: They should not participate in an employer’s 401(k) program until they have emergency savings.

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HelloWallet defines that as savings equal to three months’ income. Without that, ‘‘an economic shock, such as a car maintenance or health problem, may force the household to breach their retirement savings.’’ And, it added, ‘‘Insufficient emergency savings has the strongest association with breaching that we find.’’

The study focused on workplace-based plans, primarily 401(k) and 403(b) plans. It did not look at individual retirement accounts, or IRAs, which are also retirement savings and can be invaded before retirement, with penalties.

The report said withdrawals for nonretirement purposes by account holders younger than 60 amount to $60 billion a year, or 40 percent of the $176 billion employees put into such accounts each year and nearly a quarter of the combined $294 billion workers and employers contribute.

The study said another $10 billion left 401(k) and 403(b) plans when employees borrowed against their accounts.

HelloWallet’s chief executive, Matt Fellowes, called that combined $70 billion a ‘‘shocking figure’’ and expressed dismay that it was increasing faster than overall contributions were increasing. He said the study could not determine what amount or percentage of an account the average premature withdrawal involved, but the authors did know that the median 401(k) account had less than $17,000.

The analysis found that nearly three-quarters of those who took a premature full distribution from a retirement account did so because of ‘‘everyday basic financial management problems.” Only 8 percent cited joblessness, and only 6 percent ‘‘frivolous’’ reasons like a vacation or a purchase.

The study found a correlation, not surprisingly, between income and early withdrawals: 35 percent of households with less than $50,000 in annual income went into a retirement account prematurely; 12 percent of those with incomes over $150,000 did so. It also found higher rates of early withdrawals among blacks and Hispanics than whites. And people ages 40 to 49 were most likely to make premature withdrawals, followed by those 50 to 59.

Those who tap retirement funds must comply with Internal Revenue Service regulations and the employer’s rules.

The IRS allows withdrawals only for hardships, which are defined by each plan. They often include looming foreclosure or significant medical expenses. There are gray areas about what constitutes a hardship. The IRS has added expenses like college tuition and up to $10,000 to buy a first home to the list of allowed withdrawals.

Withdrawals are limited to half an account, to a maximum of $50,000 for accounts of $100,000 or above. But those limits do not apply to former employees. Someone who leaves a job, or loses one, can withdraw the entire balance.

Withdrawals come at a stiff cost. Whatever is taken out is subject to income tax, unless it is taken from one of the new Roth 401(k) or 403(b) accounts. Withdrawals are also subject to a 10 percent early withdrawal penalty, according to the IRS, if the account holder is younger than 59½ (or, for former employees, younger than 55 or totally disabled) unless they are for high medical expenses, higher-education costs, or a new home. Withdrawals from some Roth rollover accounts are not subject to the penalty. HelloWallet estimated that 85 percent of withdrawals were subject to penalties.

Taxes and penalties are one reason an employee with no financial cushion should consider creating an emergency savings account before contributing to a retirement plan. Another reason, the report said, is that retirement plans ‘‘come with a hefty set of unnecessary fees and inappropriate investment choices for many workers.’’

Fellowes said that not investing in a retirement plan until a worker had an emergency fund might be wise even if the employee lost an employer’s matching contributions. One reason: Matches usually do not vest immediately, so they are not available to be withdrawn.

Noreen Perrotta, editor of Consumer Reports Money Adviser, was uneasy with opting not to contribute. ‘‘I would be reluctant to advise someone not to put money into a retirement account,’’ she said. ‘‘Our advice is that they should contribute at least up to the match,’’ although that advice might not apply to someone with no cash cushion.

An alternative for the cushionless, she said, could be to put money into a Roth IRA, because there is no penalty for withdrawing principal from it.

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