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During times of crisis, it can be easy to become frantic and consider dipping into savings like 401(k)s to pay off or prevent accumulation of any debt. However, withdrawing from your savings fund too soon, especially those allocated for retirement, can negatively impact your future.
Instead, recognize that the difference between emergency and retirement funds: One is meant for short-term hardships, while the other is meant to fund your long-term future and should be left untouched.
If you are considering using your 401(k) to pay off credit debt, recognize that there are several options to obtain early access to cash without having to tap into retirement funds. Ideally, building an emergency savings fund would provide a reserve for cash emergencies in difficult times so that retirement funds can be left alone.
Did Americans’ attitude toward 401(k) withdrawals and emergency funds change during the pandemic? CompareCards turned to Chad Parks, founder and CEO of Ubiquity Retirement + Savings to find out. Early in his career, Parks worked as a CFP, mostly serving small business owners or employees, and his experience inspired him to create a new kind of retirement model. “Ubiquity was born on the mission of offering low-cost, flat-fee retirement savings plans that were simple to set up and available entirely online,” said Parks.
Q: How does the amount of 401(k) withdrawals compare to pre-pandemic times? What are the typical reasons for early 401(k) withdrawals?
Parks: At Ubiquity, we’ve observed about a 50% decrease in 401(k) loans and distribution activity from 2019 to 2020. In some cases, a distribution could imply that someone is leaving their job and taking their plan with them. It could be that those who were lucky enough to have a job when the pandemic hit earlier this year stayed put in their roles out of fear of finding another position during such an unpredictable time.
Especially in a time of crisis, we would have expected to see more hardship distributions. People tend to take withdrawals during times of personal hardship, such as the sudden loss of a job or family member.
Q: Why are withdrawals low this year, despite the CARES Act allowing eligible participants to withdraw up to $100,000 from retirement savings penalty-free?
Parks: For years, the retirement savings industry has been beating the drum on leaving retirement withdrawals as a last resort. We think this message has finally resonated.
Getting rid of this penalty under the CARES Act may actually do more harm than good by getting savers acquainted with the option of borrowing from their 401(k). Retirement accounts are typically the biggest source of cash for the average worker, and it can be tempting to tap this. Certainly, there are extreme situations where this makes sense, but it should be viewed as a worst-case scenario.
Q: What are your thoughts on using 401(k) withdrawals to pay off credit card debt accumulated during this time? How often is debt paid through 401(k) withdrawals?
Parks: While it may be tempting to look to retirement accounts as a way to pay off short-term debt, it’s extremely dangerous for your future for all the same reasons it is to borrow. If you’re lucky enough to have a retirement savings plan available at work, remember that it’s a protected asset and not subject to creditors during an extreme situation, such as a bankruptcy.
Q: How has the pandemic influenced Americans’ attitudes toward emergency and retirement savings? Do you see a shift in more focus toward funding emergency savings over long-term savings plans like a 401(k)?
Parks: Fortunately and unfortunately, the pandemic has made people realize just how important it is to maintain emergency savings. While we’re happy to see the statistics on low retirement withdrawals this year, especially during a major crisis, the takeaway from this experience will be the need to balance those short-term savings efforts with long-term savings goals.
We aren’t projecting a hard shift away from retirement savings, but rather a more concerted effort to keep emergency savings and retirement savings running smoothly in tandem.
Q: What advice do you have for consumers to figure out how much they need to save in their emergency fund?
Parks: Generally speaking, emergency funds should cover six months’ worth of expenses. To start, look at what you can afford to save every month once basic needs like food and shelter are met. Eighty percent of that savings pile should go toward your emergency fund while 20% goes toward your retirement savings until your emergency savings goal is reached. Then, you can shift all savings to go toward retirement.
My biggest piece of advice is don’t get discouraged. It might take you a while to reach that six-month goal, but every little bit counts.
Q: The pandemic has generated pent-up demand to splurge. How might this pent-up demand detract consumers from emergency savings?
Parks: People are their own worst enemies when it comes to making emotional decisions with their money. Our society is geared toward instant gratification — we aren’t wired to understand short-term sacrifice for long-term gain.
The splurge mentality is a lost opportunity that people would probably come to regret.
When the pandemic came into focus earlier this year, were you fearful and uncertain? Don’t lose those feelings. It’s important to remember what that felt like and keep money aside so you don’t have to experience it again.
Q: What is the best thing to use emergency savings on?
Parks: Emergency savings are intended for unexpected and costly expenses. Did you hit a pothole on the road and have to change your tires? Were you injured mountain biking and faced with a steep medical bill? Or maybe your kitchen sink sprung a leak and you’re in need of a repair.
These are expenses we aren’t forecasting, but could very well happen on any given day.