A New Approach to 401(k) Withdrawals

We know that people highly value liquidity when deciding where to save money for the future. This preference lives alongside the seemingly contradictory fact that successful savers often want to have a bit of “friction” between themselves and their nest egg. (The Financial Diaries has terrific real-life examples of some creative barriers that low- and moderate-income savers place between themselves and their money.)

Which brings us to retirement savings accounts and early withdrawals. Because it takes its deduction “off the top”, reducing the likelihood of good saving intentions falling victim to lapsed commitment, the 401(k) is an ideal savings vehicle.

There is contradictory evidence as to whether people are raiding their retirement savings accounts during the pandemic to meet emergency needs. But whether this is happening a lot or a little, it is the word “raiding” that I want to focus on. Personal finance media commonly describes early withdrawals from a retirement account in negative terms. It is almost universally accepted as something that is at best regrettable and at worst, a moral failing. More than a few personal finance pundits have opined that Congress erred in allowing penalty-free retirement account withdrawals in the CARES Act because it sent a message to all that retirement savings are not inviolable.

But consider another perspective. If people are less likely to save when their funds are completely and absolutely locked up, de-stigmatizing pathways to access retirement account savings early could result in more overall retirement savings. The decision to take a 401(k) withdrawal can be layered with scold, moral judgment and feelings of failure. Could making early access to retirement savings less emotionally charged have the effect of encouraging people to increase the amount that they save in retirement accounts? And still, by segregating these savings out of daily reach, the desire savers have for some barrier to their funds is addressed.

Automatic enrollment has drastically increased participation in 401(k) plans. Unfortunately, many workers only save at the low default rate, an amount that is almost certainly inadequate. This is the problem to solve for. *

Start with the enrollment process. The presentation of an early withdrawal option when one enrolls for a retirement account would be at least neutral, although arguably it could be presented as a benefit to give comfort to the commitment wary. Consider that young workers are often unable to really envision the magnitude of their future retirement savings need, causing them to underestimate the amount of their savings needed to fund their retirement. By making the exit ramp apparent, this may actually help a potential young saver overcome this mental hurdle by making it clear that they cannot “over save.”

And then rethink the current 10% penalty. First, dispose of the word “penalty” altogether. The language used to describe this transaction should send a signal to savers that they are fully empowered to make a withdrawal choice without shame. Let’s call it an “early withdrawal fee.”

A more nuanced approach to such fees can preserve the integrity of retirement accounts (which do serve the public purpose of encouraging people to save for their future, hence the tax benefit), but still address the reality that people will at times need or want to tap this fund. A zero percent withdrawal fee if the saver (or a member of the household) is unemployed, has a major health expense including long term care costs or becomes disabled, makes sense from a public policy standpoint to bolster frequently inadequate safety net programs. A further refinement over today’s hardship withdrawal would be to not include the withdrawal as taxable income when taken for this purpose.

This could be followed by a small fee (perhaps 3% to 5%) for withdrawals related to a wealth-building purpose such as a new home purchase or college tuition. Quirkily enough, currently one can withdraw from an IRA for these purposes penalty-free, but not a 401(k). The fee creates just enough friction to make the retirement account appear as a second-best option for this purpose, but not enough to completely discourage using the retirement account as a multi-purpose savings vehicle. Withdrawals for other reasons would still carry the 10% fee.

Crucially, at the time that one is considering a withdrawal, the economic choice to take an early withdrawal would be presented to the saver in easy-to-understand, dollars-and-cents terms.

For example, imagine seeing on-screen a clear analysis, in the moment, illustrating that if you proceed with this transaction, your future retirement nest egg will be reduced by $X in your target retirement year, and that the total cost that you will pay for this withdrawal today is $Y (inclusive of a fee and income tax, where applicable). Further, a bar graph could illustrate how much extra you would need to put aside each year going forward to make up for the withdrawal, based on common compound return assumptions. The withdrawal decision is now focused on a complete, nonjudgmental understanding of the financial terms of the transaction, including opportunity costs. Think of it as a real time, tech-enabled mini-counseling session.

There are worthy innovative efforts to encourage employers to support their workforce to build an emergency fund (“sidecar savings”); this idea does not displace that. Retirement account withdrawals are a poor substitute for a fully accessible “rainy day” savings cache.

In an ideal world, everyone would save aggressively for retirement and never, ever touch their 401(k) nest egg before the magic age of 59 ½. This is certainly what I promote. From a mental accounting standpoint, there is a beautiful simplicity to keeping your different savings goal eggs in separate baskets. But the paramount goal must be to simply encourage saving more, much more, for whatever purpose.

* Or rather, “a” problem to solve for. Thirty-five percent of private sector workers do not have access to a workplace retirement account.

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