Are Early Withdrawals from Retirement Accounts a Problem?

Abstract

Both adverse and investment events can trigger early withdrawals from retirement accounts. About 40 percent of retirement savings losses can be linked to these types of events, which include unemployment, the onset of poor health, primary home purchases, and college expenses. Unfortunately, lower-income families less often have retirement savings and more often tap into these savings when faced with life-changing events. The results call for an integrated savings policy that encourages savings for both pre-retirement and retirement needs.

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Introduction

Policymakers are searching for ways to increase retirement savings outside of Social Security, such as by promoting automatic enrollment in employer 401(k) plans and individual retirement accounts (IRAs). Setting aside funds regularly is not enough, however, to guarantee sufficient retirement savings. Workers must also avoid unnecessarily dipping into their savings before retirement. Many 401(k) participants cash out their balances when they leave their jobs, for example.1 Others dip into retirement accounts to cover high-expenditure needs that arise throughout their lives. It is crucial, then, that the rules governing access to these accounts before retirement properly balance family needs during periods of financial stress against safeguards that prevent spending the money on nonessential consumption.

This brief examines early withdrawals from retirement savings plans. We review the rules regarding access to 401(k) and IRA funds and analyze withdrawals by individuals ages 25 to 58 between 2004 and 2005. We also examine how withdrawals are associated with life-changing events, including adverse shocks (such as job loss, onset of poor health, and divorce or widowhood) and life-course investments (such as job changes, home purchases, postsecondary education, and the birth of a child). Our data come from the 2004 Survey of Income and Program Participation (SIPP).

We find that early withdrawals are infrequent but represent a significant loss to retirement savings. However, withdrawals are strongly correlated with adverse events such as unemployment and the onset of poor health, as well as family investments such as primary home purchases. We estimate that about 40 percent of retirement savings losses are associated with these types of events and another 10 percent of leakage is associated with job changes. Unfortunately, more vulnerable individuals, especially those with no other financial assets and those with less education, not only have the least amount of savings in retirement accounts, but also the highest withdrawal rates. This combination helps explain why these groups typically end up with little else than Social Security in retirement. The results highlight the need to strengthen our retirement and general savings policies.

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