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Early withdrawal rules for retirement plans may be too strict, researcher says

Workers took out huge sums from their retirement accounts shortly after the penalty for early withdrawals lifted, according to a recent study, underscoring how funds meant for retirees may also serve as a lifeline for those still working.

Withdrawals from traditional individual retirement accounts (IRAs) swelled in the 30 days after workers turned 59 1/2 — when the early withdrawal penalty expires, according to the study from the University of Chicago. The amounts increased three to three and a half times the baseline level from the 30 days before the expiration. After 30 days, the withdrawals declined to about double the baseline.

The pattern was consistent even among those in the highest quartile for income and IRA balances, the researchers found, and was especially pronounced for those who turned 59 1/2 during the Great Recession or recently received unemployment insurance.

The results highlight how many workers need access to their retirement savings before they actually retire and raise questions about the timing and strictness of the withdrawal penalty.

“People who made withdrawals received a lot of much-needed relief,” said Damon Jones, assistant professor at the University of Chicago and author of the study.

Old man holding american dollars.
( Photo Credit: Getty Creative) (urbazon via Getty Images)

‘A first-month surge’

Using tax records, Jones studied IRA withdrawals from 1999 through 2013 made by 12,445 taxpayers born between 1941 and 1951. About a third of these individuals had positive IRA balances the year they turned 57 1/2, according to the study.

The study focused on traditional individual retirement accounts, or IRAs, which allow early withdrawals for any reason but impose a 10% tax penalty if the individual is younger than 59 1/2. There are some penalty exceptions for death or permanent disability, first-time homebuyers, education expenses, health insurance premiums while unemployed, and unreimbursed medical expenses.

The baseline withdrawal before the penalty expiration was $4.93 per day or $1,799 per year, according to the study.

In the short run — one month prior to expiration versus one month after — the average withdrawal increased by $11.63 per day, or $4,245 more a year. In the long run — three months before versus three months after the penalty — the average withdrawal was lower, but still $5.14 per day higher than the baseline.

Senior woman using ATM in the city.
( Photo Credit: Getty Creative) (BakiBG via Getty Images)

“Once the penalty was removed, it made it easier to access funds,” Jones said. “More people who made withdrawals after they were 59 1/2 make the withdrawals in a first-month surge.”

When Jones zoomed in on those workers who turned 59 1/2 during the Great Recession, that first-month surge was even higher. Short-run IRA withdrawals during the Great Recession or after receiving unemployment benefits were four to five times higher than the baseline withdrawals.

“During the Great Recession, a lot of people were unemployed. For people who needed money, it gave them relief,” Jones said. “The penalty was in the way of their getting relief and they benefited most from earlier access to liquidity.”

Penalty holidays and legislation could help IRA participants during emergencies

Given the financial need demonstrated by the withdrawals, Jones and the other researchers of the study noted that there could be benefits from penalty holidays — exceptions to IRA early withdrawal penalties — or early withdrawal penalty expirations being moved up a year to 58 ½.

The study found that adjusting the age of IRA withdrawals could also bring in taxable revenue earlier for the government. Because IRAs are tax-deferred, there is a delay in tax revenue collected. If IRA participants who urgently needed the money took distributions a year earlier, the government could have an earlier tax collection on those IRA withdrawals.

Recent legislation could also impact IRA withdrawals. The CARES Act enacted at the start of the pandemic in 2020 let workers take up to $100,000 out of their retirement accounts without the 10% penalty. Workers could avoid paying taxes on the withdrawals if they paid the money back within three years. A TransAmerica study during the first year of the pandemic found that almost a quarter of workers took those.

The SECURE Act 2.0 also lets IRA participants take out $1,000 annually for personal emergencies.

( Photo Credit: Getty Creative)
( Photo Credit: Getty Creative) (Rudy Sulgan via Getty Images)

Jones said that penalty holidays and the current laws loosening IRA withdrawal rules could help workers who are in financial emergencies.

“With a penalty holiday, the early access could be good for people if there are high levels of need,” Jones said.

Workers have other options for IRA withdrawals

While these types of withdrawals may be beneficial to IRA participants in the short run, IRA distributions could hurt workers in the long run. That’s because they miss out on compounding interest in their accounts.

“People should be aware and think about the long-term penalties if they get their money out early and think about saving in their IRAs for the long run,” Jones said.

Kyle Shores, a Merit Financial Wealth Management who has been a financial advisor for 23 years, told Yahoo Finance that people take early or fast withdrawals after penalty expirations often because they don’t have the right financial advice.

“Most people don’t know the early withdrawal rules and don’t have a professional advisor,“ Shores said.

( Photo Credit: Getty Creative)
( Photo Credit: Getty Creative) (Ariel Skelley via Getty Images)

Shores noted that even though people can take money out of their accounts for emergencies and during penalty holidays, there are other alternatives to traditional IRAs like Roth IRAs that allow you to withdraw your contributions tax- and penalty-free. Withdrawing earnings early from Roth IRAs, though, can result in a penalty and taxes.

Shores also said that they can talk to a financial advisor about considering alternatives to typical IRA withdrawals like a 72 (t) distribution. The 72 (t) distribution lets IRA participants waive the 10% early withdrawal penalty if they take taxable equal periodic payments annually for five years.

While IRA participants could be taking out funds now with the intention to save more later to make up the difference, Shores worries that the withdrawals are just for short-term needs and won’t be paid back.

“It could lead people to save more in the future,” Shores said. “But as a realist, I doubt it.”

Ella Vincent is the personal finance reporter for Yahoo Finance. Follow her on Twitter @bookgirlchicago.

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