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More Americans Risk Savings, Tap 401(k)s Early
NEW YORK (2/12/13)--More Americans are raiding retirement savings to cover routine expenses such as mortgages and credit card bills, according to a new report. HelloWallet, a budgeting-technology website, estimated that 25% of Americans make withdrawals from their 401(k)s before they reach retirement age, to the tune of about $70 billion a year (The Wall Street Journal Jan. 25).

Similarly, Aon Hewitt, a human resources consulting firm, reported the number of participants borrowing against retirement accounts reached an all-time high in 2010. Vanguard, a large investment-management company, recently released numbers showing that, since 2008, 401(k) loans are up by 12% (The Washington Post Jan. 14).

These reports are troubling omens for millions of future retirees.

In 1980, roughly 80% of private-sector workers were covered by traditional pensions. With that number down to 20% today, 401(k)s and similar plans are crucial to workers being able to afford retirement. While that retirement nest egg is a tempting source for quick cash, especially when budgets are tight, cracking it for monthly bills puts you at risk for additional taxes, penalties and, most dire of all, not having enough to live on when you're older.

If you're younger than age 59½ and you default on a 401(k) loan or take a cash-out distribution, you must pay not only income tax but a 10% penalty on the amount withdrawn. If you're in the 25% tax bracket that means 35% of your withdrawal disappears--money that otherwise would be earning for you.

But is it ever OK to withdraw money early from your retirement savings? The short answer from most financial planners would be an emphatic, "No." However, the Wall Street Journal reports that, in a limited number of instances, siphoning money from your 401(k) might be acceptable.

These exceptions include:

  • If you make a short-term loan from your 401(k)--thus avoiding penalties--and it's for an important investment such as a house, education, or to pay off high-interest debt. Considering that the interest you pay on the loan goes to you, this could be preferable to high-interest alternatives. But given the opportunity cost from lost future earnings on the amount you withdraw, consider if a credit union loan is a smarter option.
  • If knowing the money is available leads you to contribute more to your retirement savings than you would otherwise.
  • If your circumstances are grim enough that you qualify for a "hardship withdrawal," often taken to avoid foreclosure, bankruptcy, or to pay for medical expenses. Keep in mind that 401(k) funds are protected from seizure in bankruptcy proceedings.
Most of the time, depleting your 401(k) is akin to robbing yourself. Even if you take a short-term loan, if you stop contributing to pay it back this puts you behind on savings goals. You lose compounding interest for the sum you borrowed as well as the amount you stopped contributing in order to repay it.

For more information, read "IRA Withdrawals: The Good, the Bad, and the Ugly" in the Home and Family Finance Resource Center.

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