Consequences of 401(k) Plan Leakage and Helping Savers Avoid Early Withdrawals

Image: Consequences of 401(k) Plan Leakage and Helping Savers Avoid Early Withdrawals

Saving for retirement is a long-term game, but when emergencies or unforeseen expenses arise in the short term, accessing those retirement savings can be tempting. Most retirement plans offer several different ways for participants to access their savings, whether through a qualified hardship distribution or by taking a plan loan. Early access to retirement savings—or any access before reaching retirement in the form of a distribution or loan that is not repaid—is considered plan leakage and can impact savers' ability to reach retirement readiness.

How does plan leakage impact retirement plan participants?

Plan leakage is a term used to describe the withdrawal of money from retirement savers’ accounts ahead of their retirement, resulting in loss of potential growth and, by extension, workers reaching retirement age without enough savings. There are plenty of reasons plan participants may be taking distributions from their retirement savings, but helping them understand the consequences of those decisions may lead to a decrease in early withdrawals, tax consequences, and plan leakage.

You may be interested in: What Happens When You Make an Early 401(k) Withdrawal?

During times of economic volatility, hardship withdrawals and loans may feel like an appealing solution for employees experiencing financial stress. Sadly, employees who take an early distribution before age 59½ are likely to pay upwards of 30 percent in combination of taxes and penalties—so on top of losses to the potential building up of compounding interest, savers will reach tax season primed for an unpleasant tax bill.

While retirement plan loans may seem like the best way to avoid leakage since they require the borrower to repay their early access dollars (plus interest) until the money is repaid, the power of compounding interest is decreased. Plan loans are paid with post tax money—so well they aren’t being taxed on the dollars taken out, plan loans won’t increase their income for the year even though their incoming cash increased. On top of that, loans that default are treated as any other taxable distribution from the plan and, in many cases, still have to be repaid. Early access to retirement plans in the form of distributions, defaulted loans, and loans that are paid back with post tax dollars all result in plan leakage that contributes to the larger issue of Americans reaching retirement without a firm financial foundation.

Learn more about the power of compounding interest: Time Value of Money

Strategies to help savers stop retirement plan leakage

Because many savers may take distributions without fully understanding the repercussions, plan sponsors can play a key role in helping plan participants avoid the negative consequences associated with plan leakage.

Consider plan leakage when designing your retirement plan

When you’re designing a 401(k) or other retirement plan, offering flexibility and options may seem like the obvious choice. However, some plan leakage can be avoided by carefully choosing the terms under which employees can take money out of their account. You may also choose to allow plan loans and encourage participants to take advantage of the loan option instead of the hardship distribution feature, simply because of the higher likelihood of the money being repaid over time. Depending on the options available through your plan administrator, you may also offer different loan repayment methods that could benefit participants who may otherwise default on their loan. For example, plans may allow participants to make loan payments through payroll deductions, making it less manual for an employee to repay their loan and avoid defaulting—as well as the accompanying additional taxes.

Educate employees on how to anticipate and budget for financial stress

By far, the most important thing that plan sponsors can do to help minimize plan leakage is to educate employees not only on the features available with their plan, but also on general financial wellness topics that can help them make positive decisions about their future in retirement and their savings journey along the way. While there are plenty of free tools available for employees to use when planning for their life post-career, many workers may still choose to think of their retirement plan as another savings account available to help navigate a short-term financial crisis.

When it comes to avoiding the use of plan loans and hardship withdrawal features, it can be a beneficial start to offer employees information on the impact of removing money from their account before reaching retirement. Sharing information about the benefits of creating an emergency fund and the importance of compounding interest can help participants understand how their retirement outcomes could be impacted by their short-term decisions.

For more information on helping participants see the value in retaining their savings and making regular contributions to grow their nest egg for the future, visit our Employee Resource Library.

How does plan leakage impact retirement plan sponsors?

Large companies with large retirement plans view plan leakage as a big deal; the amount of money saved in their plan has a major impact on the strength of their bargaining power in the recordkeeper and investment provider marketplace. When it comes to small business retirement plans, leakage is still an issue—but one that has much more to do with participant retirement outcomes. Because your retirement plan has a direct impact on your own future retirement, as well as those of your employees, it’s important to consider how to avoid plan leakage and help participants make the most out of their retirement savings plan.

With the help of the right administrator, you can offer a flexible plan to employees with plan features specifically designed with participant outcomes in mind—like proactive alerts, participant education, and responsive customer service.

If you’re interested in learning more about how Ascensus' retirement plan options help retirement savers get there, contact our retirement specialists at 800-345-6363.