With recession looming, more Americans tap retirement funds for cash. But is it a good idea?

Americans feeling the pinch of high inflation are raiding their retirement savings, an ominous sign for a country that already struggles to save for old age. The share of workers taking cash from their employer retirement plans as new loans, non-hardship withdrawals, and hardship withdrawals has all been on the rise this year, but the “most concerning is the rise in hardship withdrawals,” according to Vanguard Group, which tracks five million savers. People can dip into their 401(k) plans to borrow up to $50,000 as a loan to be repaid to their account, or take a non-hardship withdrawal while they’re still working for their company. But if they’re taking money out without a valid and serious financial need (that would be a hardship withdrawal), they’ll likely pay a 10% withdrawal penalty, and the IRS will likely withhold 20% of the amount withdrawn for taxes. The share of those taking hardship withdrawals from their 401(k) retirement plans in October reached 0.5%, the highest level since 2004 when Vanguard began tracking the data, it said. Hardship withdrawals are often the last resort for people needing money, and this could be a sign of how deep consumers’ financial distress may be running. They’re only allowed to cover an “immediate and heavy financial need,” according to IRS rules, and are subject to income taxes and, potentially, a 10% early withdrawal penalty. For a $10,000 hardship withdrawal, for example, taxpayers in the 22% bracket would owe $1,000 in penalties plus $2,200 in income tax. “We know that inflation has eroded employees’ purchasing power and is likely creating strain on family budgets,” said Tom Armstrong, vice president of customer analytics & insight at Voya Financial, a retirement, investment and insurance company. And without emergency savings, the fallback plan is often retirement nest eggs. Employees without adequate emergency savings are 13 times more likely to take a hardship withdrawal and three times more likely to take a loan from their retirement plan, according to Voya data.

When strapped for cash, is dipping into retirement savings a good plan?

Not if you can help it. “While we understand that, in some cases, individuals may have no choice but to tap their retirement accounts, it’s important to remember that people work hard for their retirement savings and should dip into them as a last resort,” Armstrong said. A hardship withdrawal can give you immediate access to cash, but it comes with significant financial impacts. Not only are there the immediate taxes and penalties to consider but also the longer-term retirement consequences. You may not be able to contribute to your workplace retirement plan for six months or more, and you could lose the compounding growth of your investments, said Nilay Gandhi, Vanguard senior wealth adviser. Compounding grows your money exponentially because you earn a return on both your original investment and on returns you received previously on that investment. But if you must tap your retirement savings, you might want to consider these two options first, Gandhi says:

• A loan from your 401(k). If your plan allows loans, they must be paid back to your retirement account, so you’re paying yourself back and not losing money. The money also isn’t taxed if the loan meets the rules and the repayment schedule is followed, the IRS said. Note, loans are capped at 50% of the vested account balance or $50,000, whichever is less unless half of the balance is less than $10,000. Also, “we’d caution that those funds are taxed and penalized if you are unable to pay the loan back and come due if you leave employment,” Armstrong said.
• Withdraw money from a Roth IRA. Because you contribute to a Roth IRA with money you’ve already paid taxes on, qualified withdrawals of your contributions are tax-free and penalty-free at any age.

How can I access cash without withdrawing from retirement savings?

Before turning to retirement savings for cash, consider some of the following options first:

• Savings. Unexpected expenses are exactly what emergency savings are meant for. So, if you have any, this should be the first place to turn.
• Bank loan. If you have a one-time expense and good enough credit to qualify for a low, fixed-interest rate, a personal loan could be a good option to access some cash quickly.
• Home equity line of credit (HELOC), if you own a home. You use your home as collateral to get a credit line that you can tap into. You only pay interest on what you withdraw, and the interest may be tax-deductible if the money goes towards home improvements. Beware though that they often have fees and variable interest rates, and the Federal Reserve is currently on an aggressive rate hiking cycle to slow inflation.
• Additional work. “If you’re able to take on part-time work. a lot of companies are still looking for people at attractive hourly rates,” Gandhi said. Nowadays, there are also a number of side hustles people can do from home, too, like selling goods on eBay or Etsy.
• Credit cards with 0% interest on purchases. “You can use one of these special offers for 12 to 18 months to cross the bridge, accordingly,” Gandhi said.
• Traditional brokerage accounts. Even with most investments dropping this year, there may still be a few winners you can cash out. The money will be subject to capital gains tax, but if you have some losses, you might be able to sell those investments and apply them against your gains to lower your tax bill.
• Flexible and health savings accounts, if your cash needs are to address health care costs.
• Borrowing from family and friends.