How’s this for a quagmire for clients? The Bloomberg US Aggregate Bond Index is modestly higher year-to-date while the S&P 500 is up nearly 20%, but somehow, some way, 401(k) and individual retirement account (IRA) balances are declining.
Alone, that’s a point advisors should note. When advisors discover why those account balances are declining, the situation becomes all the more important. A recent study by Fidelity indicates more investors are taking hardship withdrawals from retirement accounts to deal with inflation and unexpected expenses.
At the end of the third quarter, the average 401(k) declined nearly $5,000 from the end of the second quarter while average IRA balances experienced a $4,200 drop over the same span, according to Fidelity. During that period, the number of folks with retirement taking hardship withdrawals jumped to 2.3% from 1.8%.
“The increasing use of hardship withdrawals and loans underscore the need to help retirement savers develop emergency savings, which Fidelity has found to be the No. 1 savings goal among employees, after retirement,” notes Fidelity.
Hardship Withdrawals Are Hard to Digest
Obviously, life throws curve balls at us all and there are times when clients encounter unforeseen needs for more cash than they have sitting in their checking accounts.
Throw in two years of high inflation and credit card balances recently topping $1 trillion in aggregate and it’s easy to understand why some clients are tapping retirement accounts for cash. Fidelity notes 80% of those polled mentioned inflation as a source of financial stress.
Indeed, there are circumstances in which hardship withdrawals may be necessary, but if clients are astute enough to mention their consideration of such a move to their advisors prior to doing it, that’s a positive and an avenue for advisors to take action. The reasoning as to why advisors should help clients on this front is simple. Not only do hardship withdrawals permanently reduce a retirement account’s balance, they also create burdensome tax events.
“You must pay income tax on any previously untaxed money you receive as a hardship distribution,” according to the IRS. “You may also have to pay an additional 10% tax, unless you're age 59½ or older or qualify for another exception.”
Making matters worse, there are instances in which a client may not be able to resume contributing to the retirement account for six months after taking hardship funds.
More Ominous Data Points
Beyond hardship withdrawals, there are other concerning signs on the retirement account front that advisors need to be aware of. For example, Fidelity points out that in the third quarter, the percentage of investors taking in-service withdrawals rose to 3.2% from 2.7% a year earlier.
Then there’s 401(k) loans, an issue I highlighted in September. In the second quarter, the number of participants taking loans against 401(k) plans increased to 2.8% from 2.4% a year earlier while outstanding balances on such obligations ticked higher.
Adding to that misery is the fact 57% of told respondents told Fidelity that they’re unprepared to handle an unexpected expense of $1,000. Bottom line: Building emergency savings isn’t a glamorous pursuit, but it’s a service clients are likely to appreciate.