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Emergency funds are crucial when someone is hit with a financial shock, like a job loss or health emergency, in part because it keeps them from dipping into their retirement accounts.
Individuals who suffer from a drop in income tend to find themselves with “sudden, large and persistent jumps” in the likelihood of penalties from retirement account withdrawals, according to a report recently distributed by the National Bureau of Economic Research. Researchers looked at U.S. tax records for American households in the years between 1999 and 2018.
The paper focuses on the valuation of liquidity – put another way, how households view certain financial products and their access to that money in a quick and efficient manner. An ideal product would be widely available to households and have a price attached, which allows the account holder to decide and benchmark their worth against alternatives. People who have a higher valuation of liquidity are willing to take up pricier borrowing to spend today than tomorrow, the researchers said.
Retirement account withdrawals, even when penalized, appeared to be a common source of quick money for households, especially when money was needed in the short-term. Even though withdrawals were infrequent, Americans often took large sums of money from these accounts at a time to make up for the loss of income, and used that money for current spending, the researchers found.
See: Here’s how Congress wants to combat early withdrawals from retirement accounts
A 20% decline in income led to 9% of Americans making withdrawals that came with penalties, the report said. Even wealthier households weren’t properly prepared for these income shocks.
Some Americans are more likely to tap into their accounts than others, such as people in financially underdeveloped areas or in Black communities, the researchers found. This may be a result of a lack of access to credit sources – for example, affected areas saw more penalties from IRA withdrawals during the Great Recession as well, potentially because of credit restrictions.
Turning to credit cards is rarely the right solution to an unexpected and undesirable income shock. One of the greatest barriers to drawing down retirement accounts prematurely, and thus facing penalties, is the emergency fund, which might be able to hold households over as they weather an unfortunate scenario. General guidelines suggest single individuals with one income source have at least six months of expenses saved in a safe, non-risky account, while couples and those with multiple income streams have at least three months’ worth. In some instances, people may want to have more stashed away in these cash reserves – such as at least nine months or a years’ worth of expenses.
Most Americans must be 59 ½ years old to withdraw freely from their 401(k) plans and traditional IRAs but there are exceptions to the penalty rules. For IRAs, eligible exclusions include those made in the event of disability, a first-home purchase up to $10,000, higher education costs and certain medical expenses. For 401(k) and other qualified plans, death, disability, a Qualified Domestic Relations Order in relation to a divorce and medical expenses are allowable exceptions.
