The House has passed a bill enacting several changes to rules governing IRAs and 401(K) plans. The Senate is considering modifications to the House bill that will make it easier for workers to use retirement funds for emergencies. This blog post examines three proposals that are currently under consideration by the Senate.
Proposal One: The Emergency Savings Act of 2022: A bill offered by Senator Booker and Senator Young would allow employers to create an emergency fund inside a firm-sponsored retirement plan. The money in the emergency fund could be disbursed without penalty or tax at any time.
Comment One: One purpose of the emergency fund is to facilitate increased contributions to 401(k) plans by people with limited liquidity. Paradoxically, the emergency fund might not increase funds for emergencies if the household is living paycheck to paycheck. The new fund does not increase total financial resources available to households. The new fund does not prevent households from overspending. An increase in 401(k) contributions associated with lower rates of repaying consumer or student debt could make some households worse off.
Comment Two: The bill does not increase liquidity or savings incentives for people with a Roth retirement account. The Roth account already allows disbursements from contributions without penalty or tax prior to age 59 ½. An alternative way to increase use of retirement funds for emergencies is to encourage increased contributions to Roth rather than traditional retirement accounts.
Comment Three: The rationale for a tax deduction for contributions to 401(k) plans and IRAs is that the tax deduction incentivizes savings and makes both the worker and society better off. This bill gives workers a tax deduction even if they immediately spend all funds placed in the emergency account. The bill does not prevent workers from distributing all funds in their 401(k) plan by paying a 10 percent penalty and tax on the distribution. The goal of facilitating retirement savings and the goal of having emergency funds could be better balanced if the new emergency fund was coupled with a limitation on pre-retirement withdrawals.
Proposal Two: The Refund to Rainy Day Proposal: This plan requires the Secretary of the Treasury to create a mechanism through which people can place part of their tax refund into a Rainy Day Fund.
Comment One: The Treasury already allows for direct deposit of refunds to financial institutions. Private financial firms could set up a direct deposit to an emergency fund. The Treasury Direct site could create an option where some of the proceeds were automatically invested in short-term Treasury securities.
Comment Two: People with large tax refunds are probably less in need of emergency funds than people who owe taxes because people with little liquidity have a large incentive to increase their claimed exemptions to meet current needs. This tax refund provision does not assist the people most in need of emergency funds.
Comment Three: It is not clear why the government should favor direct deposit of tax refunds into emergency funds over other priorities including direct payments of student loan debt or direct contributions to health savings accounts.
Comment Four: I don’t see anything in this bill that increases the financial capability of households or alters household savings behavior.
Proposal Three: The Enhancing Emergency and Retirement Savings Act of 2021:
This plan offered by Senator Lankford and Senator Bennet would provide a penalty-free distribution from retirement plans, both in firm-sponsored plans and individual retirement accounts. The plan provides for one emergency distributions per year if the account has $1,000 vested funds. The maximum withdrawal would be $1,000. The legislation requires replenishment of the withdrawn amount prior to additional withdrawals.
Comment One: A worker who is replenishing an initial withdrawal has an incentive to reduce 401(k) contributions to maintain consumption. This proposal will have at best a modest impact on retirement savings, especially for workers entering the workforce with substantial student debt.
Comment Two: I presume (perhaps falsely) that this penalty-free option is optional. Some firm 401(k) plans and some IRA management firms might choose to not offer this option to keep administrative costs and fees down. The impact of the provision on administrative costs and returns on retirement funds could be considerable.
Comment Three: Some 401(k) plans will provide emergency distributions and 401(k) loans. Workers who take both an emergency distribution and a 401(k) loan will owe substantial funds to their plan. Many of these workers will not replenish the emergency fund or repay the loan. Many of these workers will have an incentive to tap their entire 401(k) plan if they switch jobs. It would be easier to justify the creation of an emergency fund inside a 401(k) plan if the proposal were linked to some limitation on complete disbursements prior to retirement.
Concluding Remarks:
The proposals considered in the Senate increase access to retirement funds for emergencies. One goal of these provisions is to incentivize workers to increase contributions to retirement plans. However, under the current system many workers routinely distribute and spend substantial funds in their retirement prior to retirement.
Several studies indicate that the use of 401(k) funds prior to retirement is widespread and is a major factor impacting the number of households who might retire with inadequate financial resources in the future. Research from E-Trade financial, reported on CNBC in 2015, revealed that nearly 60% of millennials had already taken funds out of their 401(k) account. A study by the Employment Benefit Research Institute (EBRI)reveals that 40% of terminated participants elect to prematurely take out 15% of plan assets. A recent study by Wang, Zhai, and Lynch found that over 40 percent of employees cashed out their 401(k) plan at separation.
Intuitively, the people most likely to tap funds from their 401(k) plans prior to retirement are struggling financially. My own study found here, reveals that people tapping funds prior to retirement tend to have high levels of debt and poor credit ratings. The sheer magnitude of the number of people who are both lacking in liquidity and tapping retirement funds suggests leakages from 401(k) plans will weaken retirement security for many households.
Any revisions to rules governing emergency distributions from retirement plans should be coupled with rules limiting distributions from retirement plans prior to age 59 ½.
Authors Note: David Bernstein, a retired economist has written several papers advocating for innovative centrist policy solutions.
The kindle book Defying Magnets: Centrist Policies in a Polarized World has essays on policies student debt, retirement savings and health care.
The paper A 2024 Health Care Proposal provides solutions to health care problems that are not currently under consideration.
The proposals in Alternatives to the Biden Student Debt Plan are less expensive to taxpayers than the Biden student loan proposals. The reforms presented here provide better incentives and reductions for future students while the Biden debt-relief proposal offers a one-time improvement for current debtors.