Inflation Alert: The Impact of Pulling From Your 401(k)

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The Cost of Rising Prices

As prices rise, incomes can struggle to keep up, as evidenced by this year’s historic pace of inflation. The resulting strain on purchasing power has left many struggling to make ends meet. The latest evidence of this comes from Vanguard Group (VTI), which has tracked so-called “hardship distributions” among 401(k) plan participants since 2004. In October, around 0.5% of workers took such a distribution, the highest level the firm has ever observed.

Most 401(k) plans allow participants to make hardship withdrawals. According to Plan Sponsor Council of America, a trade group, reasons to pull from retirement prematurely may include “major financial pressures,” but most commonly consist of medical bills, housing costs, and funeral expenses.

Why This Hurts Savers

Draining your retirement account early diminishes your ability to take advantage of compound interest on years of saving. Also, hardship withdrawals typically impose a 10% penalty if you’re under 60. Plus, you lose the ability to avoid paying income tax on whatever you would have otherwise saved.

Participants should note that hardship withdrawals are different from 401(k) loans, which can be paid back. If you take a hardship withdrawal, you’re losing out on the growth and earnings potential associated with a retirement account, unless you’re able to secure a future investment at a higher rate of return. What’s more, many employers prohibit participants from contributing to a 401(k) plan for six months following a hardship withdrawal.

Potential Alternatives

Despite the noted disadvantages, the relentless rise of inflation demands financial creativity from many families. Some immediate options to free up cash in the short term include canceling membership plans or potentially selling items you don’t need anymore.

If you are in need of a more significant cash flow, there may be other ways to take care of your expenses without having to tap into your 401(k). Depending on your situation, a few options could include taking out a home equity line of credit or a short-term loan.

The decision you make will depend on your individual circumstances, however, before you withdraw from your 401(k) it’s important to consider the potential long-term impact on your retirement nest egg.

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