Saturday, January 14, 2023

Withdrawal "Symptoms"

 There’s nothing like a global pandemic to fuel interest in, if not the need for, emergency savings. Indeed, there are a half dozen provisions[i] in the new SECURE 2.0 designed to make it easier for workers to tap into their retirement savings—two aimed specifically at emergency savings.

Though the financial impact of the pandemic (not to mention a series of natural disasters) has arguably been uneven, a report from Vanguard[ii] highlighted the longer-term impacts of the economic slowdown and inflation’s growing bite of the household budget. It's also widely acknowledged that concerns about the inability to fund an unexpected financial emergency is a source of stress for workers, undermining financial wellness.   

All that said, well before COVID-19, there have been concerns about Americans’ lack of emergency savings[iii] and, perhaps more broadly, that they were using their retirement savings accounts as that resource. Behavioral finance-types have counseled that a mental, if not physical, segregation of money by purpose is helpful, and at least one of the new SECURE 2.0 provisions seems designed to make that structure a reality by creating an emergency savings “sidecar” alongside regular retirement savings accounts. 

The first of these is found in Section 115 and, beginning in 2024 it says a participant may generally make a withdrawal of up to $1,000 per year from their retirement account for certain emergencies. The withdrawal may be taxable (unless drawn from Roth) and MAY be repaid within three years, but it will not be subject to the 10% penalty for early withdrawals. Only one withdrawal is permitted per the three-year repayment period—if the first withdrawal has not been repaid.

The other emergency savings provision (Section 127)—and the one that seems to be garnering most of the media attention is the (confusingly labeled) “Pension Linked Emergency Savings Accounts.” Beginning in 2024, it will ALLOW (not require) employers to create an Emergency Savings Account (ESA) as part of a defined contribution plan (401(k) or 403(b)). Only non-highly compensated employees may contribute to the account, though employers MAY auto-enroll such individuals in an EAS up to 3% of their compensation, and the EAS value cannot exceed $2,500[iv] (indexed for inflation). All employee contributions to this emergency savings account MUST be made on an after-tax basis—and each month participants may take withdrawals from the account (just to further complicate administration, the first four withdrawals for a year cannot be subject to distribution fees). 

Oh—and speaking of complications, those employee contributions must be treated as elective deferrals for purposes of any matching contributions. The matching contributions are treated by a plan no differently than matching contributions made on account of elective deferrals.   

Now this provision likely makes the behavioral science-types happy—it provides a separate mental (and notational) accounting—and one that doesn’t force the individual to choose between saving for retirement or saving for that “rainy day” emergency, at least in terms of foregoing a company match. 

But, aside from the obvious administrative complexities of this option (certainly for the plan sponsor/recordkeeper), it’s by no means clear that this kind of set up won’t create a kind of “Christmas club” account, with individuals withdrawing these contributions for just about any reason every year (just) long enough to get the match—and then the next year they could do it all over again. And again. The Treasury is authorized to issue regulations to prevent abuse, but there’s no telling if or when (or  what) those rules would be.  

It might be good mental “accounting”—but I’m not sure that it will be good for retirement. 

- Nevin E. Adams, JD


[i] While I’m focusing on only two of those provisions here, the others are Section 314 (allows for up to $10,000 of withdrawals from plans and IRAs in cases of domestic abuse, effective 2024), Section 326 (exempts from the 10% excise tax withdrawals from plans and IRAs in cases of terminal illness, effective now), Section 331 (allows for withdrawals from plans and IRAs of up to $22,000 in federally declared disasters, effective retroactively to Jan. 26, 2021), and Section 334 (allows for up to $2,500 a year of withdrawals from workplace plans to pay for long-term care, effective three years after enactment (so generally not until 2026)).

[ii] In fact, that report, published last October, and amidst growing concerns about the above factors and volatile investment markets, noted that the share of workers taking cash from their employer retirement plans through new loans, non-hardship withdrawals, and hardship withdrawals were on the rise in 2022.  Called out for special note was the rise in hardship withdrawals, which Vanguard said had reached an all-time high—though that was only 0.5% of workers tracked by Vanguard (5 million participants in 1,700 employer-sponsored retirement plans administered by the firm).

[iii] The most widely repeated likely being the Federal Reserve survey asking Americans if/how they’d handle a $400 emergency (approximately 1 in 9 said they couldn’t, and while that’s a minority, the headlines have tended to highlight the impact)—but see https://www.minneapolisfed.org/article/2021/what-a-400-dollar-emergency-expense-tells-us-about-the-economy.

[iv] Though there’s been some question as to whether $2,500 is “enough” (there’s language in the bill calling for a study to see if it needs to be higher).

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