Understanding Early Withdrawals from Retirement Accounts

Abstract

Less-advantaged individuals are less likely to have IRAs and 401(k)s, and those who do are more likely to withdraw savings before retirement. About 40 percent of withdrawals can be linked to adverse or investment events, including the onset of poor health, job loss, home purchases, and college expenses. Another 10 percent occur at job change for what may be reasonable expenses. Half of withdrawals can not be attributed to the events we could observe and may represent unnecessary loss of retirement savings. The results show the importance of policies that preserve retirement savings and increase savings for non-retirement events.

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Introduction

Many Americans do not save outside of Social Security for retirement. In 2009, only 20 percent of private sector workers under age 65 were enrolled in employer pension plans that will pay a defined benefit in retirement (U.S. BLS 2009). Another 43 percent worked for employers that offered retirement savings plans such as 401(k)s,1 but only 70 percent of them elected to participate.2 Pension coverage and participation for public sector workers is much more common. Workers can also contribute to individual retirement accounts (IRAs), but only about 10 percent did so in 2004 (Bryant 2008).

Policymakers have been searching for ways to increase retirement savings. For example, the Pension Protection Act of 2006 encouraged employers that offer 401(k) plans to automatically enroll new employees by offering employers more legal protections. More recently, President Obama’s 2011 budget calls for employers with more than 10 workers that currently do not offer pension plans to set up automatic IRAs for their employees. Employers would automatically deduct 3 percent of workers’ pay and deposit the money into their IRAs. Employees could opt out of this retirement savings deduction or change the amount deducted. The impetus behind automatic enrollment comes from numerous studies documenting higher participation in pension plans where participation is the default rather than an opt-in choice (Beshears et al. 2009; Choi et al. 2004; Madrian and Shea 2001).

Of course, increasing pension participation is only part of the solution for increasing retirement savings. Participants also need to preserve their savings for retirement. The numerous rules governing IRA and 401(k) plans help to discourage withdrawals. Early withdrawals often generate tax penalties, and individual employer pension plans can further restrict withdrawals. Nonetheless, retirement assets held in 401(k) plans, especially IRAs, can easily be tapped to finance preretirement needs. Recent estimates indicate that 3 percent of assets in IRA and 401(k) accounts are withdrawn annually by individuals under age 60.4

This study examines early withdrawals from retirement savings plans and how they are associated with life-changing events. Other studies of 401(k) withdrawals usually consider only those that occur with job separations. It is also important to understand withdrawals outside of job departures, particularly since most employers allow hardship withdrawals from 401(k) plans. In addition to the retirement assets in 401(k) plans, large sums of retirement assets are held in IRAs. While it is well known that most of the IRA assets result from rollovers at the point of job change, little is known about what happens subsequently to these assets. This study uses Census data from 2004 and 2005 to examine all withdrawals from 401(k)s and IRAs and understand how these withdrawals are related to life-changing events. We find that withdrawals, while relatively infrequent over a two-year period, represent a significant loss to retirement savings. However, we also find significant correlations between withdrawals and adverse family events such as unemployment and the onset of poor health, as well as family investment needs for primary homes and education, suggesting that early withdrawals help families meet some important preretirement financial needs.

We begin by discussing how much families have in retirement savings accounts and the rules governing withdrawals from these accounts. Then we review past literature describing early withdrawals. Next we describe our methods and the basic data underlying the results. We begin the results section by describing the characteristics of retirement account owners and their balances. We then examine the characteristics of those who withdraw from their retirement accounts and the share of their balances withdrawn. Finally, we explore the correlations between life events and withdrawals. The last section draws implications for current retirement income policy.

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