Americans' New Piggy Bank: The 401(k)

Strapped savers pay a price to tap their retirement accounts

Cindy Cromie needed money to rent a U-Haul and start a new life. Her employer, the University of Pittsburgh Medical Center, had outsourced Cromie’s medical transcription work, cutting her income by as much as 60 percent, she says. So last year, at age 56, she quit and moved about 90 miles from her home in Edinboro, Pa., into her mother’s basement. To pay for the move, Cromie pulled $2,767 out of retirement savings. “We made two trips, and it just got to be real expensive,” she says. “That money, it was a security that I needed.”

For decades, as real estate values rose, Americans tapped their homes when they needed cash by refinancing their mortgages or taking out home-equity loans. Since the housing collapse of 2008, that’s often not an option. Retirement accounts have filled the void. The Internal Revenue Service in 2011 collected $5.7 billion in penalties from Americans who withdrew about $57 billion from retirement accounts before they were supposed to. Adjusted for inflation, the government collects 37 percent more money from early withdrawal penalties than it did in 2003. “They get hit with the penalty at exactly the time when they’re the most vulnerable,” says Reid Cramer, director of the Asset Building Program at the New America Foundation, which tries to improve savings for lower-income families. “So it’s a real double whammy.”

Money in tax-deferred retirement accounts can be withdrawn without penalty after age 59 1/2 and generally must be withdrawn starting after age 70 1/2. Withdrawals, at any age, are added to a taxpayer’s income and taxed at regular rates. The 10 percent penalty for 401(k) plans applies to early withdrawals, except in cases of disability and certain medical expenses. Americans who leave their jobs at or after age 55 also can escape the penalty. Withdrawals from individual retirement accounts have a broader set of exceptions to the penalty, including spending for higher education and first-time home buying.

The median size of a 401(k) is $24,400 as of March 31, with people older than 55 having $65,300, according to Fidelity Investments. The company estimates that people will need savings of eight times annual income (in their last year of work) to live comfortably in retirement. One reason retirement balances are so low is that many younger workers who switch jobs don’t bother to roll over their accounts. Younger workers ages 20 to 39 have the highest cash-out rates, with about 40 percent taking money out when they switch jobs, according to data from Fidelity.

“The pervasive thinking is, ‘Why bother rolling over $2,500? The taxes and penalties aren’t that daunting,’” says Michael Branham, a financial planner at Cornerstone Wealth Advisors in Edina, Minn. “What’s missing is the longer-term thinking in that decision-making process.” A 30-year-old who cashes out $16,000 could lose $471 a month in retirement-income cash flow by not leaving it invested in a retirement account, assuming retirement at age 67 and death at age 93, according to a Fidelity analysis that assumes a 4.7 percent annual return and a 401(k) balance at retirement of $87,500.

That loss of income is especially troubling as Americans depend more on retirement accounts and less on pensions with set payouts. According to a Gallup survey released on May 2, 48 percent of nonretired Americans plan to rely on retirement accounts as a major source of income, up from 42 percent in 2009, though down from 54 percent in 2008.

During the 2008 presidential campaign, Barack Obama proposed allowing penalty-free withdrawals of as much as $10,000 from retirement accounts. That idea went nowhere and wasn’t included in the 2009 economic stimulus. In 2012 the New York State Society of Certified Public Accountants proposed a temporary waiver of the penalties while families were recovering from the recession. “The reality is people are going to do it,” says Jonathan Horn, a New York accountant who helped write the proposal. “And if someone needs that money, the 10 percent is not stopping them.”

Moving in the opposite direction is House Ways and Means Committee Chairman Dave Camp, a Michigan Republican. In his 2014 draft plan to revamp the U.S. tax code, Camp proposed repealing the penalty exceptions for higher education and first-time home purchases, contending that doing so would encourage Americans not to tap their retirement accounts early.

Cromie is now 57 and still jobless. She’s trying to avoid dipping into the $7,000 in her remaining retirement account. “It’s just a worry that I have every day,” she says. “I have this pit in my stomach.”

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