Is It OK to Tap Your 401(k) for Quick Cash?

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J.R. Whalen: Here's Your Money Briefing for Wednesday, March 13th. I'm J.R. Whalen for the Wall Street Journal. The stock market's been hitting new records over the past few months, and that's been good news for 401(k) account holders. Those higher balances are also leading a lot of people to use their retirement account as a quick source of cash.

Anne Tergesen: Prices for key things like childcare, groceries, continue to rise at levels that people find painful. People are taking on more credit card debt. So some of these people are turning around and finding, "Look at that, I actually have some savings. Yet, I need some cash."

J.R. Whalen: But is it a good idea? We'll talk to Wall Street Journal Reporter, Anne Tergesen, after the break. More people are taking early withdrawals from their 401(k) accounts. Wall Street Journal Retirement Reporter, Anne Tergesen, joins me. Anne, how are people's 401(k)s doing in general right now?

Anne Tergesen: In general, they're actually doing pretty well. The average account balance is up about 19% in 2023, and savings rates, by many measures, are rising. So overall, people with 401(k)s are generally in good shape, if you look at the averages. There are some metrics by which that story is not true. For example, you alluded to rising rates of early withdrawals from 401(k)s for emergency purposes. And it is true that such withdrawals, which are referred to as hardship withdrawals in the industry, that those reached a record 3.6% of participants at Vanguard 401(k) plans in 2023. So 3.6% is a pretty small percentage. However, that is a record level and it's up from 2.8% in 2022.

J.R. Whalen: The labor market is strong and we've seen employee wages trend higher. So why are people taking early withdrawals from their 401(k)s?

Anne Tergesen: It's hard to know for sure what motivates individual people. However, we're seeing trends that indicate the economy is faring well. For example, like you said, the labor market is strong. We're seeing real wages after inflation rise for a lot of workers. However, we're also seeing some negatives. For example, inflation is still trending above the 2% that the Fed wants to see. So therefore, prices for key things like childcare, some groceries, have continued to rise at levels that people find painful. Credit card debt reflects that. People are taking on more credit card debt. So you're seeing a divergence there. And I think the 401(k) data also reflects a divergence. A lot of people are doing very well. Those who can afford to save are really saving. They're amassing larger and larger balances. The market has done well over the past year. However, there also are a lot of people who maybe aren't doing as well and who feel the need to rely on their 401(k) savings in an emergency. Another factor I should mention is automatic enrollment in 401(k) plans. That's become much more the norm than it was even five or 10 years ago. And as more people are automatically enrolled in 401(k) accounts, you have more people amassing savings than would have been the case if they had to enroll voluntarily on their own. A lot of people who are automatically enrolled would not have done so on their own. So some of these people are turning around and finding, "Look at that, I actually have some savings. Yet, I need some cash."

J.R. Whalen: For people who do need to take an early withdrawal, do they need to have a documented reason for doing that?

Anne Tergesen: Under the hardship rule provisions, you do need to have specified reasons. For example, preventing foreclosure or eviction is a big one. You can use hardship withdrawals to pay tuition bills. You can use it to pay medical bills. There's a host of reasons that are officially recognized by the IRS. However, the rules have changed. Plans don't have to accept the IRS rules. They can vary by plan.

J.R. Whalen: Now, just to be sure, if somebody does make an early withdrawal, do they have to pay that money back?

Anne Tergesen: No. If you take a hardship withdrawal, you're taking that money out. If it's a traditional 401(k) account, you're paying income tax on the money you withdraw. If you're younger than 59 and a half, you're also probably paying a 10% penalty on your withdrawal. So that money comes out permanently. So that is a real downside of these hardship withdrawals. People really shouldn't take them unless they absolutely need the money.

J.R. Whalen: What other ways can somebody tap into their 401(k) without taking on the hardship distribution?

Anne Tergesen: So if you want to tap into your 401(k), another way to do so is to take a 401(k) loan. A lot of plans allow this. It's a way that people can borrow. Exactly what it sounds like, you can borrow against your 401(k). And the benefit of a loan versus a hardship distribution is that with a hardship distribution, you're really cashing that money out. You're paying income tax, you're paying potentially a 10% penalty if you're younger than 59 and a half. With a loan, you're taking that money out, but you're going to repay yourself with interest. So for a lot of people, that's an attractive alternative. There are downsides to loans as well. So it's something that people need to consider.

J.R. Whalen: Does the law stipulate how much money people can take out of a 401(k) for hardship reasons?

Anne Tergesen: Under the law, it says that people can take out what they need to meet the hardship. It's sort of on the honor system a bit, but some employers require people to actually submit proof of a hardship, maybe in the form of an eviction notice. Other employers allow their workers to what they call self-certify the hardship. Which means I come to the employer and say, "I'm experiencing this hardship," but they don't require me to submit the documentation.

J.R. Whalen: And what does the law say about money you can take out if you're going for a loan?

Anne Tergesen: So with a loan, the law says participants can borrow up to half of their balance or $50,000, whichever is lower. Some employers allow people to take out more than one loan at once. Other employers cap it. Some employers impose waiting times between paying off one loan before you can take another. So you really need to be familiar with what your plan allows.

J.R. Whalen: And if somebody does need money for hardship or to take out a loan, would the first step be to go to their 401(k) administrator?

Anne Tergesen: Yes, that is a good first step. And the law used to require people to take out a loan before they could take a hardship distribution. Often that's not a bad way to proceed if you need the cash. The downside to a loan is that if you don't pay it back, then basically the plan treats it as if you have taken a distribution. And they deem it a distribution, which requires you to pay income tax and potentially a penalty on it anyway. So you could end up in the same situation. But with a loan, you have a little bit more flexibility to potentially pay yourself back.

J.R. Whalen: So the 401(k) as a source of money can definitely help people out. But at its core, this is not what the 401(k) is for, right?

Anne Tergesen: No. The 401(k) is a retirement account, and it's designed to help people save for retirement. And a growing number of employers are really trying to take the decision-making out of the hands of their workers. They're automatically enrolling them. They're automatically increasing their savings rate each year, unless the employees opt out. And the inertia effect is such that most people stay in and allow their savings rate to increase each year. On the flip side, because people often don't pay attention to their 401(k), there are some people who maybe take on more debt than they would otherwise because the money's coming out of their paycheck and going into their 401(k). So it's kind of a nuanced situation. And for some people, the 401(k) in this country has been also built with the idea that some flexibility should be built in so that people can reach that. For a lot of people, the 401(k) is where they save their money and they don't have a lot of savings outside. So I think there's also been an effort to ensure that people who really do need access to their money can get it in a pinch. If you're paying a 10% penalty, that's not ideal either. So they're trying to give people carrots and sticks. But the idea and the goal is to help people save for retirement.

J.R. Whalen: That's WSJ Reporter, Anne Tergesen. And that's it for Your Money Briefing. We'll be back tomorrow with WSJ's Rachel Wolfe to discuss how our expectations for how much things should cost haven't caught up with reality. This episode was produced by Ariana Aspuru, with Deputy Editor, Chris Zinsli. I'm J.R. Whalen for the Wall Street Journal. Thanks for listening.