The Big Problem With 401(k)s And IRAs

It’s among the most popular and common financial advice: If you have access to a workplace retirement plan, particularly a 401(k), max out your contributions, especially if there’s an employer match. 

You hear the same about Individual Retirement Accounts (IRAs). The tax advantages with respect to long-term retirement planning can’t be beat. So max out your annual IRA contributions, traditional or Roth. 

While The Juice agrees with the general sentiment, there’s a case to be made for not using tax-advantageous accounts if you’re unable to stay the course, which includes keeping your money tied up until retirement. 

We’ll go into detail in a future 2024 Juice on retirement, but, for now, just know that, in some cases, the IRS might allow you to take money from a 401(k) plan to cover certain expenses without paying a 10% penalty on the early withdrawal. If you don’t qualify for an exception, you might have to pay income tax, plus a 10% penalty on your early withdrawal. Similar rules apply to IRAs. 

Again, we’ll cover those relatively complex ins and outs at a later date. The focus today is broader. It deals with the larger matter at hand, rather than the rules that might or might not govern a specific situation. 

The larger matter at hand being …

• Bank of America (BAC) estimates that 401(k) plan hardship withdrawals were up 27% in Q3/2023 versus Q1 of the same year, with the average amount being just above $5,000 per withdrawal. 
• Fidelity says the number of people taking a loan from their 401(k) is up and 1.7% of the people in the 401(k) plans they administer have taken hardship withdrawals. 

While your employer doesn’t have to permit hardship withdrawals, many do and this and other data The Juice reviewed shows people are taking advantage of it. This trend ties to the dwindling savings/increased credit card debt story we’ve been covering for roughly two years now. It keeps getting worse (savings down, debt up), which likely helps explain people tapping their 401(k)s for emergency cash. 

We can only assume people are doing likewise with IRAs, which have the same or similar rules around taxes as 401(k)s, but don’t require employer consent or cooperation. We say assume because data on early IRA distributions is scant. And we don’t trust the few surveys out there that use self-reported data. 

But it makes sense in a country where the financially struggling live paycheck to paycheck and the relatively well off live hand to mouth. You spend your income. You’ve exhausted your savings. You’ve maxed out your credit cards. You need cash. So tap the 401(k) or IRA any way you can. 

Or maybe you’re the type of person who’s comfortable, but can’t just let a large nest egg sit, even while letting it sit is the key to building wealth. Some people are like this. And you don’t hear them talked about in association with the prevailing max out your retirement account advice. 

You’re better off keeping your investments in a taxable account if your finances are precarious (as in, not long-term predictable or sustainable) or you know you can’t resist the urge to say taxes be damned, I want that $10,000 or $20,000 in my checking account to pad my spending. At least you’ll have “emergency cash” in readily-available investments you don’t have to jump through hoops and pay out-sized taxes to liquidate. 

Which brings us to the last part, which maybe should have come first:

• As we discuss retirement, it’s important to discuss sound personal finance first.
• You probably shouldn’t be investing in anything until you have the basics in order. 
• The basics being reasonable spending that’s below your means, steady income and little to preferably no high-interest debt.  
• If you check those three boxes, there’s a greater than zero chance you run monthly budget surpluses. 
• The first thing to do with those surpluses is build an emergency fund, designed to cover the types of situations people use retirement money to cover as a last resort. 
• Once you’ve amassed, say, 3 to 12 months’ worth of expenses, you’re ready to start investing. 

While there are no guarantees, following these steps can help avoid deterring the power of compounding in tax-deferred retirement accounts such as 401(k)s and IRAs. 

The Bottom Line: The news isn’t all bad. BofA also noted that 21.3% of Generation Z and 10.4% of millennials have increased their 401(k) contribution rates. Less than 3% have decreased the money they’re taking out of their paychecks. 

This ties into our nickel’s worth of free advice. 

It can feel amazing to be able to contribute to a 401(k). However, until you know you’re financially steady and stable, it might make sense to start with a small percentage. Once you see that you don’t need or miss that money from your paycheck, you can up your contribution, just as a solid chunk of the much-maligned millennials and Gen Zers are doing. 

If you have good visibility on your cash flow, spending and saving, this easing-in process shouldn’t take more than a few months. Time well spent to avoid reversing course after you’ve gone all-in.

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