Final rules issued recently by federal regulators make it easier for 401(k) participants to withdraw their retirement savings early in the event of a hardship, which could have the effect of increasing so-called
leakage from workplace retirement plans but may also encourage hesitant employees to boost their 401(k) savings.
Participants in 401(k) plans are able to tap their accounts if they experience financial hardships such as medical and educational costs and costs associated with purchase of a primary residence. The Treasury Department and the Internal Revenue Service issued final
rules this month that both expand the circumstances under which participants can get a hardship distribution and allow them to access a greater portion of their 401(k) funds.
"The final regulations make it easier for participants to access hardship distributions — in both direct and indirect ways," said Jennifer Rigterink, an attorney at law firm Proskauer Rose.
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Hardship distributions are a somewhat controversial topic in retirement policy circles. About 80% of 401(k) plans allow for them. Just 2.3% of 401(k) participants take hardship distributions.
Some observers say hardship distributions should be discouraged since they are a form of leakage, meaning they lead to money flowing out of a 401(k) plan prior to participants' retirement and thereby diminish their retirement savings. Participants must pay income tax on the withdrawal, as well as a 10% penalty if they pull the money out before they've reached age 59½.
Each year, roughly 1.5% of assets leak out of 401(k) plans and individual retirement accounts before investors reach retirement age, the Center for Retirement Research at Boston College found in a 2015 paper. This leakage reduces aggregate age-60 retirement assets by more than 20%, according to the center.
However, others think making it potentially easier to tap savings could prove beneficial because it could encourage more employees to participate in workplace retirement plans if they know they'll be able to access their money if necessary.
"It's the absolute worst thing to do [from a savings standpoint]," lawyer Charles Humphrey said, citing the tax ramifications. "It's a bad deal."
"But on the other hand, maybe people wouldn't contribute if they felt like they don't have a safety valve," added Mr. Humphrey, a former attorney at the IRS and Department of Labor.
Under current rules, employees can't make 401(k) contributions for six months after they take a hardship distribution. That, experts said, likely dissuades some participants from taking a hardship withdrawal since they're then unable to immediately replenish their retirement account.
The new rules, largely in line with proposed hardship rules issued in November 2018, require employers to eliminate that six-month suspension — so employees can continue making 401(k) contributions again despite taking a hardship withdrawal.
"I think participants had to make a potentially hard choice," said Teresa Napoli, an attorney at law firm Sidley Austin. "They don't have to make that tough decision anymore."
In addition, the old rules said 401(k) plan sponsors had to require participants to take a plan loan first before they were able to request a hardship distribution. Experts say 401(k) loans are a better financial choice for participants since taxes aren't owed on the loan if it's paid back on time, and participants must pay themselves back, with interest, over time.
New rules, however, which take effect in January 2020, allow plan sponsors to scrap this requirement.
The rules, issued last Monday, also allow participants to access employer matching contributions, employer nonelective contributions (a profit share, for example) and investment earnings for hardship distributions, in addition to employee contributions. Previous rules only allowed participants to tap their own contributions to the plan.
"It's a big deal, because it opens up a lot more money available for a hardship distribution," Mr. Humphrey said.
However, it's tough to say how many plan sponsors will voluntarily change these elements of plan design that could encourage more leakage, experts said.
"It will depend on the plan sponsor and their goals for the retirement plan," Ms. Napoli said.
