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Retirement Accounts Are the New Emergency Funds

Photo illustration by Sarina Finkelstein/Barrons; Dreamstime (2)

More workers are tapping their retirement accounts early to cope with financial stress, according to third-quarter data from Fidelity Investments.

Internal Revenue Service rules penalize early withdrawals of money in 401(k) plans and other tax-advantaged accounts prior to retirement, but there is some leeway for withdrawals in a limited number of circumstances that constitute “immediate and heavy financial need.”

The share of plan participants taking these hardship withdrawals rose to 2.3% in the third quarter from 1.8% in the same period last year, marking a gain of 28%. While the overall share remains low, that increase could be a sign that prolonged inflation is taking a toll on household finances.

The top two reasons that Fidelity plan participants gave for taking out the money were avoiding foreclosure or eviction, and medical expenses.

Loans against 401(k) plans, which are subject to different rules, are up over the past year as well. In the third quarter, 2.8% of participants took a loan from their 401(k), up from 2.4% in the same period of 2022, Fidelity found. The share of workers with a loan outstanding grew to 17.6% from 16.8% during that time.

Unlike hardship withdrawals, which are taxed to the participant and not repaid, loans must be repaid. The loans aren’t taxed if rules and repayment schedules are followed.?

The increased use of retirement accounts as emergency funds underscores the need to help workers set aside separate accounts for a rainy day, Fidelity said in a release. Workers ranked emergency savings as their top goal after retirement savings, according to the company’s research.?

The Secure 2.0 Act, passed at the end of last year, provided for the creation of in-plan emergency savings accounts. Starting next year, employers will have the option of including a so-called PLESA, or pension-linked emergency savings account, within their retirement-plan offerings.

Employees may contribute up to $2,500 a year to these posttax accounts, indexed for inflation. If employers provide matching contributions to 401(k) accounts, they must also offer a match for PLESA contributions. PLESA contributions count toward the annual 401(k) contribution limit, which for 2024 is $23,000 for people under 50 and $30,500 for people 50 and over.

Despite the uptick in hardship withdrawals and loans, most retirement savers stayed the course in the third quarter, Fidelity found. Among Fidelity plan participants, the average total savings rate for that period was a solid 13.9% including employee and employer contributions, just shy of the recommended 15%.

Write to Elizabeth O’Brien at [email protected]