The purpose of saving for retirement in an IRA or 401(k) plan is to have money during your retirement years. Many people who retire leave the workforce permanently and choose not to work part-time. In this scenario, you will need income to supplement your Social Security benefits.
This is one of the main reasons the IRS tries to get workers to save money in an IRA or 401(k) plan via tax breaks. He wants people to save for retirement and, just as important, he wants savers to leave their savings alone until they reach their golden years.
But new data from Vanguard reveals that a growing number of savers are prematurely drawing down their retirement savings. And that means they may run out of money later in life.
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A worrying trend
Some 401(k) plans allow savers to take what are called hardship withdrawals, which are needed to meet an immediate financial need. And Vanguard reports that the number of hardship withdrawals hit an all-time high last October.
Why the increase in hardship withdrawals? It is fair to point the finger at inflation.
Since the second half of 2021, the cost of living has only increased. While lawmakers were generous with stimulus aid in 2020 and 2021, this year there was no federal stimulus pay to help workers boost their incomes. The combination of no aid and inflation could be a big driver of 401(k) hardship withdrawals this year.
Rising borrowing costs may also play a role. The Federal Reserve has steadily raised interest rates this year in an effort to slow the pace of inflation. This made consumer borrowing more expensive. Thus, 401(k) savers may be more inclined to simply dip into their own cash reserves to meet a need for money rather than face exorbitant interest rates on personal or home loans.
A cycle worth breaking
It’s easy to see why savers have been more inclined to withdraw when their retirement accounts run into trouble. But this is far from a positive trend.
Although many 401(k) plans allow hardship withdrawals, savers who take advantage of them must pay taxes on the money they withdraw, as well as a very costly 10% early withdrawal penalty. In fact, it’s a big myth that the penalty is waived for hardship outs. Often this is not the case.
But perhaps an even bigger problem is that those who withdraw funds from their retirement savings during their working years risk running out of income later in life. That’s an especially big concern these days, given the potential for reduced Social Security down the line.
As such, savers really should do all they can to avoid plundering their nest egg before they are supposed to. In fact, everyone, regardless of age, should have an emergency fund with enough money to cover several months of essential bills. Increasing emergency savings could help some people avoid having to dip into their long-term savings when life throws them a financial challenge that they need help to recover from.
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