Penalizing Precarity

Goldburn P. Maynard Jr.* & Clinton G. Wallace** December, 2024

Retirement policy in America is oriented around 401(k) plans and other employer-sponsored savings plans, which together will receive a whopping $1.5 trillion in tax subsidies over the next decade. This Article uncovers a harmful flaw in the policy governing withdrawals made prior to reaching retirement age: an unnoticed gap between the rules governing plan distributions and the rules imposing penalties on employees in certain situations. Employees are generally required to seek approval from their plan administrator to receive a “hardship distribution.” These requests are granted for employees who face an “immediate and heavy financial need,” such as eviction or an unexpected medical expense. However, even with this approval, these distributions are frequently subject to an “early withdrawal penalty” under a separate regime that is not coordinated with the hardship distribution rules.

We document instances of employees who were able to survive financial calamity because of a hardship distribution only to learn that they now face a tax penalty—resulting in another cash crunch. Retirement plans disburse over $16 billion in hardship withdrawals each year, and the funds go to the most financially precarious households—ones that have fewer assets, lower incomes, and are more likely to be Black or Hispanic. Recognizing the existence of this gap also exposes a fundamental flaw in retirement savings policy: under the existing rules, some workers are made worse off by trying to make use of 401(k) plans. This Article introduces several reforms to protect against penalizing financial precarity by integrating hardship distributions with the early withdrawal penalty regime. We also explore broader reforms to effectively reduce financial precarity among lower-income and lower-asset households.

Introduction

Tiffany¹ arrived at our Volunteer Income Tax Assistance preparation site in Columbia, South Carolina, looking for help filing her tax return.² She provided multiple W-2 forms³ from her employment during the year as well as a 1099-R form⁴ showing a distribution of around $4,300 from her 401(k) plan.⁵ Tiffany explained that she had made the withdrawal because she had fallen behind on her housing payments and was facing eviction; the withdrawal was necessary to keep her and her three young children from becoming homeless. She was able to use money from her account in accordance with the “hardship distribution” rules that allow withdrawals before a taxpayer reaches retirement age.⁶ These rules include a safe harbor that deems eviction an “immediate and heavy financial need,” allowing the plan administrator to pay out funds to prevent eviction.⁷

The 1099-R form Tiffany presented to us included a distribution code of “1,” an inscrutable demarcation.⁸ We explained to Tiffany that this meant that the amount was presumptively subject to a 10 percent early withdrawal penalty tax.⁹, There is no exception to this separate penalty for payments made to avoid eviction despite a taxpayer qualifying for the hardship distribution safe harbor. Thus, people like Tiffany, who are already struggling to make ends meet, often get saddled with an extra, unexpected tax bill.¹⁰ Further, in Tiffany’s case, there was no tax withheld on her distribution. Nearly six months after surviving a near-eviction experience, she would need to pay both income tax and an additional penalty on the funds she used to stave off calamity.

This type of situation is all too common among financially vulnerable Americans, and we have seen it countless times in our Volunteer Income Tax Assistance (VITA) tax preparation program.¹¹ The 10 percent additional tax was conceived with two primary justifications.¹² First, it was conceived as a commitment device to discourage individuals from dipping into retirement savings during their working years (what experts sometimes call “leakage”).¹³ Second, it was intended to recover tax benefits intended to promote retirement that are not actually used in that way.¹⁴

Not only are these taxpayers ill-positioned to be influenced by the incentive effect of the additional tax (because, like Tiffany, they are often unaware of it before the withdraw funds), but the additional tax is imposed on taxpayers who have not received any tax benefits to be recaptured. This is because the tax benefit of 401(k) plans is the tax-free return on income earned on investments in the account,¹⁵ which means that magnitude of the tax benefit that might be recaptured depends on each taxpayers’ marginal tax rate on investment returns.¹⁶ Under reasonable assumptions—namely that low-income taxpayers would be subject to the statutory zero percent rate on long-term capital gains—a low-income taxpayer may be worse off for having put money into a 401(k) plan that she later needs to withdraw that is subject to the early withdrawal penalty than if she had simply paid tax on the money initially and invested the after-tax proceeds.¹⁷

The reality, then, is that the 10 percent additional tax works as a penalty, borne most heavily by poorer Americans who use their retirement savings to survive in times of desperate need.¹⁸ Poorer and nonwhite taxpayers who have the smallest retirement account balances are most frequently penalized,¹⁹ and penalties are also often imposed on people who have experienced layoffs.²⁰ Perversely, these taxpayers are subject to the extra tax because they are in the most precarious financial position during economic shocks.²¹

Conversely, the early withdrawal penalty is seldom imposed on wealthy households, and the distribution and penalty waiver rules can actually work to their financial benefit.²² Perhaps this is because the 10 percent additional tax does work as an incentive for those with more resources; additionally, perhaps, they may not need to use their retirement savings for unexpected pre-retirement expenses. The waiver rules also help these wealthier families build more wealth, as they are able to pay advisors to help them take advantage of several statutory penalty waivers that are largely inaccessible to the poor.²³

If Tiffany were a higher-income individual, she could have avoided the 10 percent penalty by taking a loan from her account rather than making a withdrawal.²⁴ But retirement plan loans require repayment to start almost immediately, often through paycheck deductions, which Tiffany could not afford even if she was made aware of the possibility.²⁵ Similarly, if Tiffany had arranged a series of annuity-type payments in equal amounts over a number of years, her withdrawal would be penalty-free.²⁶ But these alternatives were not options for Tiffany, and they highlight the absurd regressivity of the gap between hardship distribution rules and early withdrawal penalties: Higher-resource people, particularly those with access to financial planners and tax advisors, have myriad ways to use retirement plan assets early and without penalty.²⁷

The federal government is slated to spend over $1.5 trillion on tax subsidies for employer-sponsored defined-contribution retirement plans over the next decade.²⁸ Scholars have recognized that these plans largely heap tax subsidies on the already-well-off,²⁹ and recent policy changes have also often been in service to those whose retirements are already relatively secure.³⁰ This distributionally slanted aspect of defined-contribution plans is a significant deficiency in American retirement policy, particularly as these plans have come to dominate the landscape of employer-provided retirement benefits.³¹ Our analysis of the application of hardship distribution rules and early withdrawal penalties reveals insult added to injury: Despite how commonplace financial emergencies are for lower-income Americans, the financial precarity that many Americans experience is not effectively considered in the basic statutory framework that governs defined-contribution retirement plans.

In this Article, we dissect the hardship distribution and early withdrawal rules, showing how together the rules fail the low-income, low-resourced population that most often dips into their limited retirement savings to avert financial disaster.³² We uncover a pervasive misperception about hardships and the penalty regime that works to the particular disadvantage of taxpayers who do not have the means to hire a tax expert to assist with tax planning and preparation. Specifically, many people believe that once a taxpayer receives approval from their employer or retirement plan to receive a hardship distribution, the withdrawal will not be subject to any financial penalties. This is wrong.

The hardship distribution terminology and rules are addressed to the legal authority of the retirement plan, acting as a fiduciary to the participants and their beneficiaries, to allow a withdrawal from funds held in trust.³³ The early withdrawal penalty regime is a separate, and essentially uncoordinated, set of rules meant to incentivize workers to leave their retirement savings alone. The lack of clarity resulting from the asynchrony of these two regimes undermines the potential preclusive effect of the penalty, as the distinction between hardship distribution policy and early withdrawal policy often seems to be lost on taxpayers until the penalty comes due at tax filing. Further, we found that taxpayers are not alone in misunderstanding the situation—employers and retirement plan administrators seem to think that penalty exceptions apply when, in fact, they do not. Policymakers, too, have failed to grasp that taxpayers can be caught with surprise tax bills.³⁴

We introduce reforms to integrate the hardship withdrawal rules with early withdrawal penalty exceptions.³⁵ If these heretofore separate regimes can be made to match and complement one another, then a taxpayer receiving a hardship distribution would qualify for an exception to the early withdrawal penalty.³⁶ Among other reforms, some of the existing exceptions should be reshaped to benefit workers who lack resources and access to sophisticated financial planning.³⁷ Even in cases where an exception does not apply, we propose ways to administer the distribution so that taxpayers become aware of the financial repercussions before the withdrawal is made.³⁸ We argue these reforms will work to protect financially vulnerable taxpayers and enhance the effectiveness of the penalties as a commitment device, appropriately focused on those who should truly preserve funds for retirement.

To the extent that a category of non-hardship withdrawals persists—that is, withdrawals that are permitted but subject to penalties—we propose that it be identified consistently by alternative terminology.³⁹ We propose “excess withdrawal,” which indicates a withdrawal that is beyond or outside of the penalty-free amount permitted for a hardship withdrawal and does not satisfy other withdrawal requirements.⁴⁰ We argue that reforming both regimes and unifying the hardship withdrawal rules with the early withdrawal penalty rules will promote financially secure retirement for the non-wealthy and avoid penalty taxation imposed on those who have no resources to spare.

Additionally, this Article links the problems with the withdrawal penalties to pervasive deficiencies in American retirement security policies.⁴¹ We make the case that some of the incentives built into the defined-contribution retirement savings paradigm generally, and the penalty waiver rules for early withdrawals specifically, urge lower-income people to act against their own economically rational interests. These existing policies essentially ignore that, in some circumstances, lower-income households rationally prioritize emergency spending needs over retirement savings. In addition to the more modest reforms we propose to the existing early withdrawal rules, real retirement security requires a commitment of public resources to support retirement for the most vulnerable, and furthermore, policies that allow them to be able to save for retirement and have a rainy-day fund for emergencies. In short, we make the case that retirement security requires getting more money with more flexibility into the hands of the poor.

The Article proceeds as follows. Part I surveys the landscape of defined-contribution retirement plans and describes how 401(k) plans came to dominate retirement savings policy.⁴² As discussed further in this first Part, our focus in this Article is on 401(k) plans and their close relative, 403(b) plans. Other employer-sponsored defined-contribution plans have distinctive rules,⁴³ and individual retirement accounts (often referred to as IRAs) are subject to some of the same penalty rules (although penalty-free withdrawals are permitted with more leniency), but do not suffer from the gap addressed in the Article because there is no employer involved in the administration of the account.⁴⁴

Part II describes the gap that exists for 401(k) plans between hardship distribution rules and the early withdrawal penalty rules and exceptions. This Part also discusses the normative goals that undergird these rules and critiques the rules for failing to achieve these goals for low-income taxpayers. Part III proposes fixes to the existing hardship distribution and early withdrawal regimes, in two channels. First, we propose introducing income- and asset-based waivers for the early withdrawal penalty, on the basis that the penalties for low-income and low-resource people do not work as a commitment device, do not effectively recapture misplaced tax benefits, and are distributively unjust. Second, we propose integrating hardship rules with early withdrawal rules and improving communication and clarity on how these rules work in practice so that taxpayers, operating without the benefit of paid advisors, are able to navigate them. Part IV turns to the broader issues raised by our critiques of the defined-contribution retirement plans: namely, how this approach fails to serve taxpayers who do not have and will not have adequate resources to be able to save for retirement. A final Part concludes.

I. 401(k) Plans in Context

In the language of federal income taxation, a “qualified” retirement plan is one that qualifies for tax benefits by way of meeting intricate requirements prescribed by Congress and the Department of Treasury.⁴⁵ Qualified plans allow for tax-free investment returns, either by way of a deduction from gross income in the year of contribution or an exclusion in the year of distribution.⁴⁶ For “traditional” plans, income taxes are generally only due when funds are distributed from the plan to the employee, so long as the employee has reached retirement age at the time of receipt;⁴⁷ for “Roth” plans, income taxes are due up front and withdrawals for retirement are not subject to tax.⁴⁸ Further, the rules allow employers to deduct currently some amounts they contribute to the plan, even though employees will not receive those amounts until later.⁴⁹

A century ago, most employees had no retirement benefits whatsoever.⁵⁰ For those who did, the primary vehicle for private retirement savings was a type of qualified retirement plan called a defined-benefit plan—commonly known as a pension.⁵¹ Under the defined-benefit model, the employer funds an annuity that guarantees a certain level of income for the retiree until death.⁵² These plans began to catch on under the early income tax statutes following the ratification of the Sixteenth Amendment in 1913,⁵³ which allowed corporations to take deductions for contributions made to employee pensions.⁵⁴ lowering their federal corporate income tax bills.⁵⁵ However, employees covered under these plans had no guaranteed right to this future income, leaving them vulnerable. Further, these plans were not offered to most employees.⁵⁶

Retirement security became a more prominent policy concern during the Great Depression, which gave rise to the Social Security Act in 1935.⁵⁷ Around the same time, the National Labor Relations Act empowered labor unions, which then successfully pushed for increased pension benefits and expanded coverage for private sector employees.⁵⁸ World War II fueled further growth of private employer pensions, partly because pensions were exempt from the wage freeze imposed during that time.⁵⁹ In response, employers competed for workers by offering more generous pension benefits.⁶⁰

Around the same time, Congress increased the top marginal tax rates and introduced special tax deductions for establishing pension plans.⁶¹ Under these new rules, for the first time, companies were required to include workers other than top executives in pension plans.⁶² These changes, along with increased union pressure, extended coverage further. By the end of 1950, over 10 million Americans, or more than 25 percent of the private-sector workforce, had a pension,⁶³ and 10 years later, about half of the private-sector workforce had one.⁶⁴ Some scholars consider this period the heyday of employee retirement security because Social Security assured most workers of income until death,⁶⁵ and increasing numbers of workers enjoyed traditional pensions with generous life-long benefits to supplement Social Security.⁶⁶

Although pensions dominated the private retirement benefit landscape, employers also made use of defined-contribution plans, often to supplement pensions.⁶⁷ Defined-contribution plans, which first received federal tax subsidies in 1921, provide an individual account balance that accrues to the benefit of an employee at retirement age.⁶⁸ Initially, defined-contribution plans were either profit-sharing or stock-bonus plans in which an employer made a contribution to the plan on behalf of an employee—the employee, however, had no autonomy to decide whether to take the payment in some other form.⁶⁹ The basic structure gave the employer discretion and flexibility to decide not to make contributions in years in which there were no profits to share. In the 1950s, the IRS approved Cash or Deferred Arrangements (CODAs), a new feature for defined-contribution plans that allowed employers to offer employees a choice as to whether to receive an amount in cash or to have it contributed to a trust as deferred income held on the employee’s behalf.⁷⁰ CODAs were the precursors to the modern 401(k) plans.⁷¹

Through the 1960s, even as the IRS allowed the expansion of CODAs,⁷² Congress, the IRS, and the public were increasingly concerned about the lack of regulation of private retirement plans, prompted in particular by the spectacular failures of some pensions. When Studebaker-Packard Corporation notoriously collapsed in 1963, its pension was so poorly funded that thousands of its employees lost some or all of their promised pensions along with their jobs.⁷³ By the 1970s, calls for pension reform were rising and the IRS became increasingly concerned about defined-contribution plans as well.⁷⁴

Congress responded in 1974 by enacting the Employee Retirement Income Security Act (ERISA). The new law put rules in place that established federal oversight and regulation of employer-sponsored retirement and health care plans, including funding requirements for defined-benefit plans so that employers had to set aside assets to follow through on promises made regarding later pension payments.⁷⁵ ERISA also temporarily halted IRS plans to severely restrict CODA plans through regulation. Instead, it mandated a study of employee salary reduction features and included provisions that would facilitate individual account plans.⁷⁶ Among other things, the law introduced Individual Retirement Accounts (IRAs), which are not employer-sponsored plans but share some features with the employer-sponsored account plans that would follow.⁷⁷ The groundwork laid in ERISA led to the enactment of section 401(k) of the Tax Code in 1978, in which Congress blessed the CODA concept by allowing employees to elect to defer income by channeling it into a retirement plan featuring an individual account balance.⁷⁸ In 1981, the Department of Treasury proposed regulations facilitating the use of elective deferrals under section 401(k).⁷⁹ By 1982, several companies like Johnson & Johnson, PepsiCo, and JCPenney were offering plans and nonprofits were offering annuities under section 403(b) that worked in a similar fashion.⁸⁰

Today, about two-thirds of working families have some sort of retirement savings or pension.⁸¹ Around 13.5 percent of workers have a defined-benefit pension, and around 34.6 percent of workers have assets in an employer-sponsored defined-contribution plan.⁸² This broad category includes several related but distinct retirement plans beyond those to which section 401(k) applies, and they are each subject to different particular rules.⁸³ Our analysis focuses on “401(k) plans,” which we refer to as such despite some technical nuance.⁸⁴ Although we focus on 401(k) plans, the same rules (and, thus, our same critiques and proposals) apply to annuities and accounts governed by section 403(b), which can be offered by tax-exempt employers and in practice work similarly to 401(k) plans notwithstanding a few minor distinctions that we note along the way.⁸⁵ Together, 401(k) plans and 403(b) plans hold $8.7 trillion of assets, which is 82 percent of the total assets held in employer-based defined-contribution plans.⁸⁶

In these plans, employees can decide whether to direct compensation to a retirement account on a pre-tax basis or receive the compensation currently as cash.⁸⁷ The retirement benefit to each employee varies based on how much the employee contributes to the account and the account’s investment performance.⁸⁸ This shifts the investment risk and planning decisions from employers and plan sponsors to individual employees, which leads to employers increasingly offering defined-contribution plans rather than pensions.⁸⁹

Although this approach purports to allow employees to control their funds, defined-contribution plans suffer from some notable deficiencies compared to defined-benefit alternatives. The employee’s retirement payout is in the form of a cash balance, which means that, rather than receiving guaranteed payments until death, the retiree can only receive distributions to the extent of their savings in the account. The amount available on retirement does not depend on salary or years of service but, rather, is a product of contribution decisions and the investment performance of the account. This can be difficult for many Americans because they are not investment experts. Saving for retirement can involve complex calculations and, further, saving enough calls for correctly anticipating one’s own death.

Nonetheless, 401(k) plans have been designed with an expectation that individuals can make and stick with long-term commitments, consider the time value of money, evaluate different investment options, and shoulder the burden of significant uncertainty about their investment decisions and their future preferences—all dubious expectations in the real world.⁹⁰

These features contribute to bleak statistics about the extent to which lower-income households make use of any of the retirement accounts detailed above. In general, low-income individuals are less likely to contribute to retirement accounts.⁹¹ Although retirement accounts do increase the wealth of low-income workers,⁹² the effects are exceedingly small: According to one estimate, the lowest quintile on the income scale receives 2 percent of the tax benefit, amounting to only $6, while the top income quintile receives 61 percent, averaging $1,838.⁹³ A serious indicator that individual accounts are useless for a large swath of workers is the median retirement account balance for all working-age individuals: zero dollars.⁹⁴ This means more workers than not have no money accrued in their retirement accounts. Further, even those low-income taxpayers who do have funds in a 401(k) account may have no de facto tax benefit even if they do maintain their savings until retirement time, because of the zero percent capital gains bracket for lower-income taxpayers.⁹⁵

As the next Part describes, those who do have accounts but are struggling to make ends meet can face stiff financial penalties for attempting to save for retirement.

II. The Gap Between Hardship Distributions and
Early Withdrawal Penalties

There are two distinct sets of rules that govern what are called “in-service” distributions from 401(k) plans (i.e., distributions made while an employee is still working or could be).⁹⁶ Each regime is generally designed to ensure that savings in 401(k) plans are protected and preserved for retirement, but the rules work with different targets. First, the distribution rules are addressed to employers and plan administrators by prescribing how plan assets are to be held and protected for the benefit of plan participants.⁹⁷ These rules provide the legal authority for the retirement plan, acting as a fiduciary to the participants and their beneficiaries, to allow distributions of funds held in trust.⁹⁸ Second, the early withdrawal rules impose a 10 percent additional tax on employees for any withdrawal from a 401(k) plan, absent a specific statutory exception.⁹⁹

The basic parameters of these rules are instructive as to how these regimes should intersect. Congress made a policy determination that distributions are permissible when an employee dies, becomes disabled, or reaches fifty-nine and a half years old.¹⁰⁰ For each of these events, there are parallel rules that facilitate distributions. For the employer, section 401(k) allows funds to be removed from trust in each of these events.¹⁰¹ For the employee, section 72(t) allows funds to be received without penalty for the same set of events.¹⁰² The rules are coordinated so that if the conditions are met for the plan to distribute funds, the employee (or their beneficiaries or estate) can, because of the same conditions, receive the funds without penalty.

Beyond death or disability, “in-service” distributions are discouraged prior to reaching retirement age, as discussed below. Nonetheless, they may be permitted in certain limited circumstances without penalty, and the statutes in these circumstances reflect matching, parallel rules for distributions accompanied exceptions to the early withdrawal penalty tax.¹⁰³ Congress also deemed that a loan from (or secured by) an employer-sponsored retirement account does not constitute a distribution if the loan is less than $50,000 and is required to be paid back within five years.¹⁰⁴ This rule, thus, permits employers to allow such loans and takes them out of the penalty regime. Thus, there is a narrow, though numerous, set of circumstances in which employees are allowed to take in-service distributions or loans and are not subject to any penalty tax for doing so.

But there is a final category of in-service distributions that is not so well coordinated: “hardship” distributions. This is a subset of the rules, directed at employers and plan administrators, that permits distributions “upon hardship of the employee.”¹⁰⁵ The statute does not define hardship; rather, the exact meaning of hardship is prescribed in regulations and left to some extent to the discretion of the employers, and these distributions rules are not matched in the penalty regime.¹⁰⁶

Using IRS data and analysis from the Government Accountability Office (GAO) and other sources, Section II.A shows that the taxpayers who fall into the gap—those making hardship withdrawals subject to penalty—are among the most financially precarious. Section II.B goes deeper into the details of each regime and how those living in financial precarity fall into the gap. We explain how and why the hardship distribution rules are constructed the way they are, working through the regulations that provide significant discretion to retirement plans to shape rules for their participants. Further, we explain how and why the early withdrawal penalty waivers do not match with the hardship distribution rules. These waivers are statutory and were enacted by Congress in a series of targeted amendments to the Tax Code that decidedly do not mirror the flexibility provided under the hardship standard.

A. Who Falls into the Gap

The distribution rules and the early withdrawal penalty rules may seem like reasonable approaches to ensure that tax-preferred savings are both protected from illegitimate withdrawals and saved by the employee until retirement. But as applied to hardship distributions, the two sets of policies are mis-calibrated: there is a significant gap in how hardship distribution rules¹⁰⁷ and early withdrawal penalty rules¹⁰⁸ relate to one another. The resulting interaction has received little attention from scholars or policymakers, but based on our experiences assisting low-income taxpayers, we argue that it has troublingly regressive effects in practice.¹⁰⁹

The scope of the problem is significant. The IRS and GAO estimates suggest that taxpayers receive approximately $16 billion to $18 billion in hardship distributions in a year.¹¹⁰ Those distributions go to around 1.7 million taxpayers each year and, each year, around 1.2 million of those taxpayers are subject to the 10 percent early withdrawal penalty for some or all of their withdrawal.¹¹¹ The most comprehensive study on the issue found that the median penalized distribution amount for taxpayers younger than age fifty was approximately $3,100—meaning that about half of distributions subject to a penalty were withdrawals of less than that amount.¹¹² In short, taxpayers subject to the penalty withdrew fairly small amounts of money with large resultant tax bills.

The GAO found statistically significant differences within hardship distributions as well. Taxpayers who make withdrawals in the face of hardship are more likely to be African American or Hispanic (versus “White, Asian, or Other”), tend to be less educated (high school degree or less), have larger families (seven or more in a household), and are more likely to be widowed, divorced, or separated (rather than married or never married).¹¹³ They are also most likely to be low income (with incomes below $25,000) or somewhat low income (with incomes between $25,000 and $50,000) and to have cash reserves below $1,000.¹¹⁴ Further, they are most likely to have total retirement assets of $5,000 or less.¹¹⁵ That is, their hardship withdrawals are coming from already meager 401(k) plans. Finally, there is a higher incident of hardship withdrawals among account holders with less than three years of investment in their retirement account, compared to employees who have made contributions for longer than three years.¹¹⁶

For those who fall into the gap, the consequences can be significant. Consider a taxpayer who arranges to save $3,000 of her earnings that she can either direct to a 401(k) plan or take as current income and invest independently; assume that in either scenario she can earn 10% annually on the investment, and she is in the 12% tax bracket for ordinary income, which places her in the 0% capital gains bracket.¹¹⁷ If she saves for three years, but then needs to liquidate the investment due to a medical emergency, what is the result? In the 401(k) scenario she would have $3,993 of deferred income and investment returns after three years.¹¹⁸ The full amount would be subject to regular tax and the early withdrawal penalty, assuming no penalty waiver applies.¹¹⁹ This would give her a total tax liability of $878, leaving her with $3,115 of after tax proceeds from the initial $3,000 of deferred income.¹²⁰ On the other hand, if she takes the income as cash initially, she would pay an additional $360 in tax liability at the outset.¹²¹ Investing the after-tax amount of $2,640, by the end of the third year she would have $3,514 of assets.¹²² When she liquidates the investment to pay for her medical expenses, her long-term capital gain of $873 would be tax-free (applying the standard rate brackets),¹²³ and she would be left with $3,514. Indeed, that is exactly what she would end up with if the early withdrawal penalty did not apply.¹²⁴

All told, the taxpayers who fall into the gap between hardship distribution rules and early withdrawal penalties constitute the most vulnerable account holders. As Americans have felt increasing pain due to inflation and increasing costs of living, hardship withdrawals have increased.¹²⁵ Unfortunately, as the example above illustrates, their decision to try to save for retirement may be more costly than if they had avoided 401(k) plan investments entirely.

B. How and Why They Fall

1. Permissive Hardship Distributions

Congress prescribed that distributions from 401(k) plans are permissible “upon hardship of the employee”—hardship exists if the employee has “an immediate and heavy financial need.”¹²⁶ Under these regulations, a 401(k) plan is not required to allow hardship distributions. But, if it does, it must provide criteria to determine whether a hardship has occurred and also specify how it determines need and the amount of distribution necessary to meet such need by applying nondiscriminatory, objective standards.¹²⁷ This determination is to be based on “on all the relevant facts and circumstances,” and can include consideration of the needs of the employee’s spouse and dependents.¹²⁸ As of 2022, Congress now allows that a hardship can be established sufficiently to permit a distribution if an employee can provide “written certification.”¹²⁹

The regulations specify that a distribution is not necessary unless the participant exhausted other sources to satisfy the need.¹³⁰ A plan administrator may generally rely on the employee’s representation that he or she is experiencing an immediate and heavy financial need that cannot be relieved from other resources.¹³¹ However, an administrator cannot rely on an employee’s representation if the employer has actual knowledge that the employee’s need can be relieved through other means.¹³² A plan is allowed to add additional requirements as well.¹³³

Certain events are “deemed” to constitute an “immediate and heavy financial need.”¹³⁴ These include expenses for medical care that would be deductible under section 213(d);¹³⁵ costs related to the purchase of a home for the employee (but not including mortgage payments); tuition expenses for post-secondary education for the employee’s family; payments to prevent eviction; payments for funeral expenses; and expenses related to a natural disaster or casualty loss damage to the employee’s home.¹³⁶ The amount of the distribution cannot be in excess of the amount necessary to satisfy the immediate and heavy financial need.¹³⁷ However, a taxpayer is allowed to withdraw enough to cover all federal, state and local taxes and penalties triggered by the withdrawal, including the 10 percent early withdrawal penalty.¹³⁸

The existence of the hardship standard shows that policymakers appreciated that some workers may need to dip into their retirement savings before they retire. But in the regulations, policymakers have largely ceded the details to plan administrators; as a result, the rules vary across plans. Indeed, plans are not required to offer hardship withdrawals—each plan has discretion to dictate specific circumstances that constitute a hardship in its governing documents.¹³⁹

In recent years, the rules restricting hardship withdrawals have been relaxed, starting with the Bipartisan Budget Act of 2018.¹⁴⁰ Whereas previously individuals were required to stop making contributions to the plan for six months following a hardship distribution, that rule was eliminated to allow employees to keep making modest contributions so as to keep benefitting from an employer match following a hardship.¹⁴¹ Additionally, employees were previously required first to take a loan from their plan before making a hardship withdrawal; they no longer need to do so.¹⁴² Further, participants facing a hardship can now withdraw not only the amounts they themselves previously elected to contribute, which was the prior rule, but also their earnings and certain employer contributions as well.¹⁴³ These rules go a long way to facilitate hardship withdrawals that previously were not possible, particularly for lower-income people with low account balances. None of these recent rule changes were accompanied by changes to the early withdrawal penalty regime.

Thus, for any hardship distribution described above, if an employer permits a hardship distribution in accordance with plan rules that comply with Department of Treasury regulations governing hardships, then the plan has fulfilled its legal duties as a custodian and fiduciary of the plan assets.¹⁴⁴ However, for 401(k) plan account holders, the hardship process is just the first set of regulations that they must confront.

2. Limited Early Withdrawal Penalty Waivers

The early withdrawal penalty constitutes a second category of rules governing 401(k) plans, targeting employees (rather than plan administrators) with economic incentives in the form of an extra 10 percent tax on in-service withdrawals.¹⁴⁵ The penalty regime includes numerous exceptions (also called waivers) that recognize circumstances in which the penalty is not appropriate, notwithstanding Congress’s stated goals of encouraging the preservation of retirement savings and recapturing tax benefits that were intended to promote retirement security.¹⁴⁶ These waivers include a few new additions enacted in 2022 as part of the SECURE 2.0 Act.¹⁴⁷

Problematically, these rules seem to have been conceived independently from the plan rules that govern hardship distributions. Consider medical expenses, which are a major source of financial precarity¹⁴⁸ and which anecdotally are a frequent cause of early withdrawals, as reported by VITA clinic taxpayers.¹⁴⁹ Emergency medical expenses are predetermined via regulations to constitute a hardship that justifies an in-service distribution.¹⁵⁰ There seems to be an accompanying exception to the 10 percent withdrawal penalty.¹⁵¹ But on close examination, there is a gap between the two rules: The hardship withdrawal safe harbor provided in the regulations allows any medical expense described in Tax Code section 213(d) to constitute a hardship (if the taxpayer does not have an alternative source of funds with which to pay the expense).¹⁵² In contrast, the penalty exception is limited to medical and dental expenses that would qualify for the deduction under section 213.¹⁵³ This section imposes a significant hurdle: medical expenses are only deductible to the extent that they exceed 7.5 percent of the taxpayer’s Adjusted Gross Income (AGI) for the year.¹⁵⁴

In practice, a taxpayer might get approval for a hardship distribution based on an unexpected or unusually high medical expense as defined in section 213(d),¹⁵⁵ but then learn at tax time that some, or all, of the distribution amount is subject to the 10 percent penalty because the medical spending did not exceed the AGI floor and qualify for a deduction under section 213.

For example, if a taxpayer has an adjusted gross income of $45,000 and withdrew $5,475 from her retirement account to pay medical expenses that fall within section 213(d), she would multiply $45,000 by 7.5 percent to find that only expenses exceeding $3,375 can be included as an itemized deduction under section 213. This leaves her with a medical expense deduction of $2,100 ($5,475 minus $3,375). As a result, the first $3,375 of the distribution would be subject to the 10 percent penalty, while $2,100 would be exempt from the penalty, leaving the taxpayer with an almost-certainly-unexpected penalty tax of $337. If her income were $30,000 and she withdrew $2,000 for a medical expense, the penalty tax would apply to the entire amount.

This penalty waiver produces unexpected penalty taxes, not only because of the confusing calculation required, but also because the medical expense safe harbor for hardship withdrawals does not contain similar limitations, a problem that we have encountered repeatedly with actual taxpayers who must pay the penalty tax. For example, Sara,¹⁵⁶ another taxpayer we assisted through the VITA program,¹⁵⁷ fell into this gap, with medical expenses that she could not afford without dipping into her 401(k) account—but she did not qualify for any penalty waiver. Sara presented a Form 1099-R showing a distribution of a few thousand dollars from her 401(k) retirement account, which she attributed to a medical emergency. Like Tiffany and so many others, her form showed a distribution code of “1.”¹⁵⁸ Sara was surprised when we told her she was subject to a penalty tax for the withdrawal, because her employer had allowed the withdrawal once she provided the explanation of her medical need. We determined that, despite the high out-of-pocket costs for her medical issue, she would not qualify for the “medical expense” exception to the early withdrawal penalty.¹⁵⁹ The immediate financial result devastated Sara: The early withdrawal increased her federal income tax liability by almost $900—including nearly $400 from the early withdrawal penalty—moving her from a modest refund to an amount owed. She did not have that much cash available and asked us in desperation to help her set up a payment plan with the IRS.

The medical expense gap is relatively narrow, in that there are hardship distribution rules and penalty waiver rules for medical expenses. Other gaps are much wider. A taxpayer who takes a hardship distribution to prevent eviction or foreclosure,¹⁶⁰ like Tiffany,¹⁶¹ does not qualify for a penalty waiver.¹⁶² Similarly, a hardship distribution is permitted for a taxpayer to pay college expenses for a child,¹⁶³ and although there is a penalty waiver for these expenses in section 72(t) of the Tax Code, it only applies to IRA account holders.¹⁶⁴ For the other circumstances that are deemed to constitute immediate and heavy financial need—including withdrawals for home purchases¹⁶⁵ and burial or funeral expenses of a family member,¹⁶⁶ there is no penalty waiver for 401(k) plans at all.¹⁶⁷

In contrast, there are penalty waivers for a variety of early distributions that do not constitute hardships and that require complex legal and accounting advice to make use of. For example, 401(k) plans are permitted to allow withdrawals for a series of “substantially equal periodic payments,” sometimes referred to as SEPPs, that are made at least annually for the life or life expectancy of the account holder.¹⁶⁸ These SEPPs are also exempt from the 10 percent withdrawal penalty.¹⁶⁹ Thus, these rules allow a person with ample retirement savings to set up regular annuity-style payments from their retirement account beginning before retirement age without penalty. The IRS provides three methods of determining payment amounts that conform with the statute, each of which involves somewhat tricky calculations based on the balance in the account and the life expectancy of the account holder or the account holder along with a beneficiary.¹⁷⁰

The inflexibility of the rules makes this a prime example of the penalty waiver rules catering to the well-resourced, both in substance and practice.¹⁷¹ In order to make regular early withdrawals under this rule, the account holder must feel comfortable that their retirement savings are sufficient to cover their normal retirement as well as this extra time. Additionally, the rules lock in the equal payments for five years or until the taxpayer reaches fifty-nine and a half years old,¹⁷² which means that the account holder must have other funds available for any additional unexpected financial needs.¹⁷³ In any event, arranging for payments over time is not a useful option for taxpayers with low retirement account balances, and equal payments over time do not solve acute immediate financial needs faced by lower-income people.¹⁷⁴

Although there are many waivers, they remain exceedingly narrow in scope and create a mishmash of ways in which taxpayers must carefully and proactively plan their affairs in order to avoid the 10 percent penalty.¹⁷⁵ Of course, careful planning is not an option for many taxpayers, particularly lower-income taxpayers.¹⁷⁶

C. Recent Modifications

The most recently added exception to the hardship distribution and penalty waiver rules also does the best job of coordinating between the two to address the needs of lower-income workers. Starting in 2024,¹⁷⁷ the new provision allows for one “emergency personal expense distribution” of up to $1,000.¹⁷⁸ The statute explains, echoing the hardship distribution standard, that a qualifying expense is one borne by the “individual for purposes of meeting unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses.”¹⁷⁹ Importantly, the statute meshes the penalty exception with the hardship distribution standard by providing that the plan administrator can rely on an employee’s own certification that a qualifying immediate financial need has arisen.¹⁸⁰

This exception, which was accompanied by a handful of other limited penalty waivers as well,¹⁸¹ is clearly oriented toward facilitating penalty-free withdrawals in times of unexpected financial need—but it will still prove insufficient for many low-income workers. The $1,000 penalty-free withdrawal comes with strings attached: An employee who withdraws this amount cannot make any further withdrawals in the three succeeding years, unless or until the employee has “re-paid” the withdrawal by making additional contributions of at least the amount of the initial withdrawal.¹⁸² These limitations are particularly miserly, and in our VITA experience emergency withdrawals often come to a few thousand dollars.

Still, these existing penalty waivers do not tell the full story of hardship distribution and early withdrawal penalty policies. One element of the hastily enacted rule from the COVID-19 emergency legislation in March 2020 provided for expanded distribution options and favorable tax treatment for 2020 withdrawals up to $100,000 distributed from 401(k) plans through December 2020.¹⁸³ Penalty-free withdrawals were permitted for individuals (and their spouses and dependents) who were either diagnosed with COVID-19 or suffered adverse financial consequences from the pandemic.¹⁸⁴ In addition to the penalty waiver, the regular income tax on these COVID-19 related distributions could be spread out over a three-year period, starting in 2020.¹⁸⁵ For example, if a taxpayer received a $90,000 COVID-19 distribution in 2020, she would report $30,000 in income on her federal income tax return for 2020, 2021, and 2022, allowing her to spread the regular income tax bill (i.e., the inclusion of previously deferred income) over time.¹⁸⁶

Congress enacted a special rule to allow taxpayers to avoid all tax liability for COVID-19 withdrawals repaid in full or in part, provided that the repayment was within three years after the date that the distribution was received.¹⁸⁷ Specifically, if the taxpayer repaid a COVID-19 withdrawal, the distribution would be treated as though it were repaid in a direct trustee-to-trustee transfer so that the taxpayer would not owe federal income tax on the distribution.¹⁸⁸ If, for example, a taxpayer received a COVID-19 distribution in 2020, chose to include the distribution amount in income over a three-year period (2020, 2021, and 2022), and chose to repay the full amount to an eligible retirement plan in 2022, she could file amended federal income tax returns for 2020 and 2021 to claim a refund of the tax attributable to the amount of the distribution that she included in income for those years. She would not be required to include any amount in income in 2022.

* * *

Although we object on distributional grounds to some of the penalty waivers more than others, we agree that each may be justifiable viewed in isolation. However, the aggregate effect of these technical rules is a thicket that might create the impression that a taxpayer can avoid paying penalty taxes on hardship distributions. In reality, the rules are quite limited, and the complexity may be difficult or impossible to navigate successfully. In true situations of hardship for low-income people operating on their own, the best option is the most recent addition to the Code: the limited $1,000 penalty-free withdrawal.¹⁸⁹ However, this is an insufficiently narrow and limited waiver, particularly considering the disconnect between hardship distribution rules and the narrow availability of early withdrawal penalty relief that often draws unsuspecting people to withdraw what they later cannot afford.

III. Bridging the Gap for the Most Financially Precarious

The application of the hardship distribution and early withdrawal penalty rules can be financially devastating for workers living in financial precarity. Tiffany¹⁹⁰ was fortunate to receive a refund despite the unexpected extra tax bill she faced after her withdrawal to prevent eviction. Still, it was clear that the several hundred dollars of additional cash she might have received in the form of a larger refund would have made a huge difference after the challenging year behind her, and as she worked to support herself and her kids. For other taxpayers, like Sara,¹⁹¹ an early withdrawal penalty can move them from receiving a refund to owing money to the federal government—money that they often do not have.

This Part proposes some specific policy responses to eliminate the gap between hardship distribution rules and the imposition of early withdrawal penalties in ways that can benefit taxpayers like Tiffany and Sara. These proposals seek to aid the most financially vulnerable and insecure workers in accessing their retirement savings in times of financial distress by making early withdrawals easier and less costly.

The proposals that follow aim to protect the integrity of the early withdrawal penalty as a commitment device for higher-income savers. The proposals also reflect that the recapture justification may be mistargeted in regard to taxpayers with the lowest incomes and lowest account balances.¹⁹² Perhaps counterintuitively, we anticipate that policies that reduce the barriers to accessing retirement savings for low-income people could help to increase savings rates at lower-income levels. Workers who are aware of the precarity of their own finances may appreciate a clearly communicated policy and a retirement account that they can contribute to without risking further financial harm. Further, removing the additional tax for some low-income taxpayers eliminates a penalty that can put them in a worse position than they would have been in if they had avoided making 401(k) contributions to begin with.

A. Harmonizing the Two Regimes

First and foremost, the hardship distribution and early withdrawal penalty rules and waivers should be harmonized in a way that can work for taxpayers who do not have access to sophisticated tax advisors. This will address the confusion that we believe pervades in this entire regime: that 401(k) account holders are not aware that permission to receive a hardship distribution does not make them exempt from early withdrawal penalties. This reform would make more hardship distributions qualify under a broader penalty waiver. We propose to do this based on an income or asset test, so that lower-income households, lower-wealth households, or lower-asset 401(k) plan participants could avoid the penalty in any case of hardship.

The most accommodating version of this reform would keep the current hardship standard intact and adjust the penalty waiver rules for qualifying plan participants. If the penalty waiver rules completely aligned with the hardship standard, at least for more financially precarious taxpayers, it would allow taxpayers to withdraw with certainty that they would not face a penalty. We propose to follow part of the model of the emergency withdrawal rule that takes effect in 2024, allowing the recipient to assert a hardship and permitting that assertion to extend to allow a penalty waiver.¹⁹³ As discussed below, this approach might curtail the commitment device effect of the penalty for some and could have a revenue cost for the government. But we suspect it may also facilitate low-income retirement savings by giving some employees comfort that they can make contributions without later suffering consequences of depositing funds in an account out of reach in case of emergency.¹⁹⁴ Further, it will eliminate the penalty aspect of the additional 10 percent tax to the extent that the tax can result in taxpayers actually having greater tax liability on their savings in 401(k) plans than they would if they simply invested after-tax earnings in capital assets that would allow them to include long-term capital gain at the zero percent rate.¹⁹⁵

A key challenge in this reform is defining who qualifies for the more lenient penalty waiver. We propose to create a two-tiered system for early withdrawal penalty waivers based on income, wealth, or plan assets. An income approach might allow for penalty-free hardship withdrawals for any household with income (perhaps for the prior calendar year) that qualifies them as a low-income household according to the low and moderate income (LMI) household guidelines.¹⁹⁶ Using LMI guidelines ensures the lenient waiver rules vary with family size.¹⁹⁷ Another option would be to coordinate the early withdrawal penalty with the zero percent rate bracket for long-term capital gains, so that a taxpayer who could liquidate a non-401(k) plan investment without tax liability on the gains can avoid the additional 10 percent penalty for hardship withdrawals.¹⁹⁸

Alternatively, a total wealth approach might hold that, for example, anyone with $50,000 or less in net assets, including 401(k) plan assets and other assets, could withdraw penalty-free for any hardship as currently defined in the Code and regulations.¹⁹⁹ This would be more onerous for the taxpayer because it would require accounting for all property; the IRS might rely on the taxpayer to prepare something like Form 433-A, which the IRS currently uses to collect asset information from taxpayers seeking to pay their tax debts for less than the full amount owed.²⁰⁰

For the sake of simplicity, our preferred approach would be to base the withdrawal rules on total retirement assets so that, regardless of non-retirement assets, a worker with $50,000 or less in total qualified plan assets could withdraw penalty-free in case of hardship. This would be the easiest to administer from the 401(k) plan perspective because it would allow plan administrators to primarily evaluate whether the recipient qualifies for the penalty exception without requiring additional outside information (with an exception for plan participants who have retirement assets in separate plans connected to other employment, although employers could be permitted to allow taxpayers to certify that they do not have other such assets).

Although the standard analysis of this sort of leniency would likely warn of reduced incentives to save, we think it should have the opposite effect given the reality that financially precarious household can, due to the extra 10 percent tax, end up in a worse position than they would if they did not use a 401(k) plan. By lowering the stakes for emergency distributions, this approach would allow lower-income people to set aside assets for retirement even when they recognize that they may need those assets before retirement. This would harmonize savings policy with the reality that low-income people are more likely to face financial shocks that require them to tap into retirement savings. We discuss the need for emergency savings policy in Part IV.

B. Vocabulary and Guidance

Harmonized rules should be augmented by clarified communication. Employees who almost certainly do not have financial or legal advisors assisting them should be made aware of the financial implications of early withdrawals. This communication can take several forms, and we focus on adopting common (and more expressive) vocabulary that would be shared with plan administrators and account holders through better and more plentiful guidance. This is not a particularly burdensome proposal: Plan administrators already have substantial disclosure and notice duties with regard to other types of distributions from 401(k) plans,²⁰¹ and the IRS already provides some guidance to plan administrators regarding what to do in the event an employee requests a hardship distribution.²⁰²

Anecdotally, we see low-income taxpayers face unexpected penalty tax bills because they believe that receiving approval for a hardship distribution from their plan administrator constitutes IRS sanction of their receipt of the funds. They think that the hardship approval is sufficient to waive the penalty, or more likely, they do not understand that there is an early withdrawal penalty. Without changing any statute, the Department of Treasury can reduce the number of taxpayers who confront this situation by simply changing some terminology in the regulations and other guidance.

We propose that the Treasury amend the hardship distribution regulations²⁰³ to distinguish between qualified hardship distributions, which would not be subject to a penalty, and “excess withdrawals,” which would be penalized.²⁰⁴ Although the regulations currently provide a list of financial emergencies that are deemed to constitute hardships, there is no guidance that we have found that sufficiently explains the distinction between those hardship distributions that subject the recipient to the early withdrawal penalty and those that do not.²⁰⁵ The IRS should instead produce some guidance to indicate what specific types of hardship distributions are not, in whole or in part, subject to the penalty. Guidance targeted to plan administrators should emphasize this distinction. Additionally, the Department of Treasury or Congress should impose some duty on plan administrators to communicate the distinction to plan participants prior to making the distribution so that employees are aware of the potential penalty consequences and can plan accordingly.²⁰⁶

C. Withholding Rules

The early withdrawal penalties create problems for low-income households in part because of a timing issue: Taxpayers may withdraw and spend the money as soon as sixteen months before a tax bill comes due.²⁰⁷ This problem is not unique to early withdrawal penalties—the penalty may exacerbate the trouble caused by the regular tax liability that arises from most withdrawals.²⁰⁸ Indeed, the entire tax withholding regime works to prevent this sort of tax-filing cash crunch in the ordinary course.²⁰⁹ Even some policymakers appear confused about how the withholding rules apply to hardship distributions and early withdrawals: The leading GAO report analyzing these issues misstates the law and indicates that employers must withhold 20 percent for most early withdrawals, which is incorrect.²¹⁰ In fact, employers are not required to withhold on hardship distributions, and in our experience, they do not withhold²¹¹—they do not want to take any responsibility (or, perhaps, blame) for early withdrawal penalties that an employee might face. This is particularly unfortunate given that Congress has expressly permitted that hardship distribution amounts can include additional distributions sufficient to cover the tax liability that will result from the distribution.²¹²

We propose a default withholding obligation on plans that will cover early withdrawal penalties and at least some regular income tax liability. These rules could follow the existing withholding rules for annuity and lump sum payments of certain deferred income.²¹³ The annuity and lump sum rules provide for either 10 percent or 20 percent withholding and allow for the individual recipient to elect out of withholding.²¹⁴ This withholding scheme prompts recipients to confront future tax consequences at the time money is withdrawn, and provides an appropriate solution to prevent a future tax-time cash crunch for many taxpayers.²¹⁵

If the hardship distribution rules applicable to a plan administrator become consistent with the early withdrawal rules, as proposed above, then the plan administrator can more easily be made (more) responsible for withholding the appropriate amounts at the time of distribution. Specifically, if the rules require the plan administrator to communicate whether the recipient of a hardship withdrawal will face an early withdrawal penalty, then the administrator could be required to account for that penalty, as well as income tax liability, by way of withholding at the time of the distribution. This would go a long way toward preventing the additional financial shock that results from unexpected early withdrawal penalties. The general thrust should be more one-on-one help and better use of technology to ensure low-income Americans can anticipate the consequences of withdrawals. Hopefully, this can be done in a fashion that does not result in lengthy, inscrutable written disclosures. We discuss the large administrative burdens that low-income individuals face when accessing government programs below.

D. Low-Income Loans

Loans can offer an alternative to retirement plan withdrawals and can limit the use of predatory products like payday loans. In the absence of a strong government safety net, credit is the do-it-yourself alternative.²¹⁶ This can take the form of borrowing from family and friends, but often involves high-interest loans from predatory lenders.²¹⁷ Unfortunately, low-income families struggle to access credit on favorable terms.²¹⁸ As such, payday loans operate as a “shadow welfare state,” filling gaps left by inadequate cash assistance.²¹⁹

Many retirement plans allow loans to participants, but loan administration methods—and some of the requirements imposed by Congress—put them beyond the reach of many lower-income households. As a general rule, taking out a loan or using a retirement account balance as collateral for a loan constitutes a distribution and could be subject to the early withdrawal penalty. However, the Tax Code provides a safe harbor for certain loans up to $50,000 such that penalty does not apply.²²⁰ The statute requires that these loans cannot favor “highly compensated employees” by way of more favorable terms.²²¹ But the statute also requires that loans must be repaid in equal installments, with payments made at least quarterly.²²² Plans generally require reasonable repayment. We learned from conversations with lawyers who advise plans and participants that these reasonable plans typically require payroll deductions in equal amounts over the period of the loan.²²³ This makes the loan option a non-starter for any employee who lives paycheck to paycheck and cannot cover their basic needs if their regular pay is reduced.

We propose that the Department of Treasury develop, through regulations, a low-income loan safe harbor that would facilitate a plan participant borrowing in case of emergency. Rather than requiring payroll deductions, the safe harbor would allow a loan balance to be repaid largely or even solely from employer matching contributions, even if the period for repayment would extend beyond the five-year loan limit. Alternatively, the safe harbor could allow loan repayment on a less constrained schedule: for example, allowing employees to wait to make a lump sum repayment if the employer has a practice of paying bonuses. Finally, plans could allow for deferral of repayment with a straightforward route to convert a loan into a withdrawal that either provides adequate notice of the tax and penalty consequences or qualifies under one of the proposals described above to avoid penalties.

These loan-oriented proposals would help to address the gap between hardship distributions and early withdrawal penalties and would also help with the deficiencies in credit markets for low-income households that scholars and policymakers have previously identified.²²⁴

E. Simplification

Generally, lower-income people will benefit from more lenient, less complex penalty waiver rules. Simplification of the complex existing regime aligns with calls from other scholars urging for reform of other economic security programs to achieve greater simplification, decreased administrative burden, and increased agency efforts to help individuals access benefits.²²⁵ Indeed, the early withdrawal penalty rules, particularly the newly enacted $1,000 emergency safe harbor, are not unique among policies oriented toward lower-income households that have long and deservedly been critiqued for their complex and sometimes contradictory requirements.²²⁶ Administrative burdens can reinforce inequality by preventing programs from working as they should and disadvantaging some minority groups.²²⁷

Other scholars have suggested opportunities for simplification, which we highlight here, as they may serve as a model for simplification to address the gap identified in this Article. ²²⁸ Additional communications and information from the government to low-income taxpayers would reduce compliance burdens and could provide opportunities to communicate that a retirement account withdrawal may result in a penalty or in a situation where the taxpayer will owe money instead of receiving a refund. Experience from the expanded Child Tax Credit showed that families who had never filed taxes before required high-volume outreach and hands-on assistance.²²⁹ For immigrant families in particular, it was critically important to communicate in a clear, simple, and repetitive manner.²³⁰ A one-off call or a leaflet was not enough,²³¹ so more intensive outreach would need to be incorporated into the distribution of these benefits on an annual basis. Relatedly, some have called for the federal government to give credits like the Earned Income Tax Credit to those who appear facially eligible instead of waiting for eligible low-income taxpayers to identify themselves.²³²

Simplification might preempt some hardship withdrawals that would result in penalties. It could also provide some of the informational infrastructure necessary to identify taxpayers who fall within income limitations, permitting them to make penalty-free withdrawals in accordance with one of the proposals we advance above (for example, helping taxpayers learn that they qualify to take out a low-income loan).²³³

IV. The Broader Challenge of Financial Precarity

As evidenced by the disconnect in the hardship distribution rules and early withdrawal penalty waivers discussed in this Article, 401(k) plans are an underwhelming tool to help financially precarious workers withstand emergencies.²³⁴ The deficiencies we have focused on in the 401(k) hardship distribution and early withdrawal penalty regimes stem from the broader fabric of federal retirement savings policies that do not mesh with many workers’ realities of limited ability to save.²³⁵ These limitations, in turn, are a consequence of abiding economic insecurity throughout Americans’ working years. This Part considers some deeper structural reforms that might address the challenges of precarity prior to and during retirement in more fundamental respects than the reforms proposed above.

A. The Economic Realities of Lower-Income Workers

Unfortunately, many households, including those in the middle class, live just one unexpected expense away from a major financial hardship,²³⁶ which is often the event that causes households to seek an early withdrawal from their 401(k) plan.²³⁷ A Pew Charitable Trusts study found that six in ten survey respondents reported some form of financial shock in the past year.²³⁸ The most common financial shock was a major car repair, but significant numbers of individuals also listed injuries, unemployment, and pay cuts as major hardships.²³⁹ For low-income families, the effects of these shocks often linger long after the fact. The households which experienced shocks had lower savings and carried more credit card debt.²⁴⁰ In one survey, half of the families that experienced shocks in the previous year had not recovered financially at least six months later,²⁴¹ causing increased financial anxiety among respondents.²⁴² One study from 2011 found that 25 percent of respondents had not saved at all for an emergency.²⁴³ If faced with an expense of $2,000, almost half of the respondents stated that they would not be able to cover it in a month.²⁴⁴ In short, Americans are woefully unprepared for financial emergencies.

Research suggests that Americans are struggling to stay above water not because of lavish consumption, but because incomes have not kept up with increased costs of living in recent decades.²⁴⁵ Low-income families have been hit particularly hard because of their sensitivity to rising housing costs.²⁴⁶ By 2021, researchers estimated that lower-income families spent nearly three-quarters of their income on food, transportation, rent, utilities, and cellphone service.²⁴⁷ A report by the Census found that the median low-income household spent 62.7 percent of their total income on rent that year.²⁴⁸

People struggling to meet basic needs rationally ignore retirement savings. The poorest Americans are unlikely to even have retirement accounts, as these usually require both stable employment and an employer willing and able to offer such benefits.²⁴⁹ As such, retirement policy cannot equate to economic security until more is done to allow people to support their basic needs and foster emergency savings without dipping into retirement savings.

We favor two broad policy solutions to tackle the problem of economic precarity and fragility at the bottom end of the wealth distribution: First, we recommend subsidizing emergency savings, which would decrease the use of retirement assets in times of acute need. Second, we recommend increasing more direct retirement subsidies for lower-income households, including enhancing Social Security benefits.

B. Basic Needs and Emergency Savings

Even if an individual or a family is able to take care of their basic needs, that does not mean that they are financially secure. Saving remains exceptionally difficult for LMI households largely because basic needs take up much of their available resources,²⁵⁰ although the lack of savings cannot be just explained by income.²⁵¹ Policymakers’ focus on retirement has the unfortunate effect of overshadowing the more common and pervasive problem of unexpected expenses.²⁵² Further, most current savings and investment incentives disproportionately inure to the wealthiest taxpayers.²⁵³ The challenge, as we see it, is to target those with the least resources in ways that do not rely on them having extra resources to expend.

The SECURE 2.0 Act, enacted in 2022, addresses the right targets, but in the wrong way. First, it established “pension-linked” emergency savings accounts.²⁵⁴ To contribute to a pension-linked emergency savings account, an employee must meet the eligibility criteria established by the plan and not be a highly compensated employee.²⁵⁵ Plan sponsors can also opt to automatically enroll participants into the pension-linked emergency savings account with a contribution rate no greater than three percent.²⁵⁶ The total amount in a participant’s account is limited by the plan but can be no more than $2,500.²⁵⁷ Based on our experiences with taxpayers of very modest means routinely withdrawing their entire $3,000 or $4,000 401(k) plan balances, $2,500 is inadequate and further it relies on employees being able to set that amount aside. Second, the SECURE 2.0 Act changes the existing retirement Saver’s Credit from a nonrefundable tax credit against taxes owed to a matching contribution, regardless of the individual’s tax obligation.²⁵⁸ These changes, which take effect in 2027,²⁵⁹ will make the Saver’s Credit more generous and attractive and should increase knowledge of the credit’s existence.²⁶⁰ Unfortunately, the matching scheme still fails to overcome the problem of lower-income individuals lacking sufficient resources to deposit in long-term savings, as lower-income families will still be required give up crucial liquidity in order to qualify for any assistance.²⁶¹

Thus, both SECURE 2.0 Act reforms provide benefits that mostly require people to be able to save beyond their basic needs. But this puts the cart before the horse: Research shows that low-income recipients of extra cash, primarily today accomplished through the Earned Income Tax Credit (EITC),²⁶² first use that cash to cover basic needs, but in turn these transfers will increase savings, promote individual autonomy and respect for the poor, and contribute to the overall well-being of the family, with especially pronounced benefits for children.²⁶³ Importantly, by eventually increasing savings, these transfers allow some individuals to save and withstand future financial shocks.²⁶⁴ These concerns have given rise to “universal basic income” proposals,²⁶⁵ as well as arguments in favor of a universal child allowance that would reach all children, especially the most vulnerable.²⁶⁶ This line of thought supports expanding the EITC, as a way to use existing policy infrastructure to put more money in the pockets of the most vulnerable households.²⁶⁷

C. Strengthening Social Security

Returning to retirement, how might be existing subsidies be structured in a more cohesive fashion, without heaping more benefits on affluent and wealthy Americans? Our best answer is Social Security. Almost 90 percent of Americans sixty-five or older receive Social Security income.²⁶⁸ Without Social Security, almost 40 percent of adults over sixty-five would fall below the poverty line; Social Security has kept this number around 10 percent²⁶⁹ and it accounts for a sizeable decline in elderly poverty since the middle of the twentieth century.²⁷⁰ Social Security also has strong downstream effects because Social Security recipients help their entire families by reducing dependence and adding income to the larger family unit.²⁷¹

Social Security is a form of forced savings. The U.S. government collects payroll taxes to fund Social Security and Medicare, and the program is made progressive by distributing benefits through a formula that favors low-income workers.²⁷² Additionally, while Social Security does not exempt low-income taxpayers from payroll taxes, one of the main justifications for the enactment of the EITC was to reimburse low-income individuals for their payroll taxes.²⁷³ In effect, the government recognized Social Security will need to fund the entire retirement of some individuals, even as the lowest earners continue to make at least nominal contributions via payroll taxes.²⁷⁴

Perennial (and not popular enough to be enacted) reform proposals for Social Security include “lifting the cap on taxable wages, compressing benefits for the highest-income individuals, increasing the amount employers and employees pay into Social Security . . . , and bringing all state and local workers into the system.”²⁷⁵ Professor Michael Doran proposed a more thorough overhaul that would include curtailing subsidies for higher-income workers, while leaving the status quo in place for middle-income workers, and converting various indirect retirement tax subsidies into direct government-funded enhancements to Social Security.²⁷⁶ This would radically change the structure of the retirement account incentive system. Other ambitious proposals that present robust improvements over the status quo abound as well.²⁷⁷

* * *

The ideas discussed above that address retirement and income security as well as poverty policy show that the problems we confront in this Article cannot be fixed simply by tweaking the rules around 401(k) plan early withdrawals. Rather, economic insecurity that is exacerbated by unexpected early withdrawal penalties is the same insecurity that regularly impinges on workers ability to provide for their basic needs, leaves them with limited savings for emergencies, and ultimately results in income insecurity during retirement. Thus, the circumstances caused by the combination of hardship distribution rules and early withdrawal penalty waivers serve as canaries in the proverbial coal mine of deeper challenges related to economic insecurity.

Conclusion

This Article identifies the gap between hardship distributions and early withdrawal penalties, a problem that we have seen harm financially precarious taxpayers time and again. A scheme of economic incentives that does not successfully communicate the financial consequences ex ante is failed policy. Even worse, the hardship distribution and early withdrawal regimes sometimes impose economic incentives to counteract rational decision making—that is, introducing a penalty tax for people who appropriately use limited resources to tend to immediate and urgent financial needs. The early withdrawal penalty regime sometimes leaves taxpayers worse off than they would have been if they had not used a 401(k) plan to save for retirement. This problem is exacerbated by the unexpected nature of tax bills that arise even despite a taxpayer receiving approval for a hardship distribution. Serious life challenges, like the threat of eviction and unexpected out-of-pocket medical expenses, should not result in additional taxes that have the effect of penalizing employees for having put money into their 401(k) plan. Taxpayers like Tiffany and Sara need and deserve a more transparent system that is easier to navigate. Their financial precarity resulted in each of them—and millions of others in similar situations—facing steep, unexpected tax bills shortly after surviving a time of acute financial need.

This Article proposes solutions to address the gap. We propose changes to early withdrawal penalty regime to more effectively account for the realities of lower-income workers trying to save for emergencies and for retirement, integrating the hardship distribution standard with penalty waiver rules. We propose new IRS guidance to better communicate to how the hardship distribution and early withdrawal penalty regimes interact for some employees. And we suggest additional changes to the Tax Code, particularly in the form of loans secured by even small amounts of retirement savings, that are accessible to low-income workers and thus can help employees use even limited retirement savings to their advantage in times of need, instead of penalizing them into worse financial trouble.

The gap this Article is focused on reflects a retirement security policy that at best misunderstands and at worst undermines the needs of some of the least-well-off Americans. The problem of penalizing precarity in the case of 401(k) plan hardship distributions is part of a broader array of policies that do not adequately meet the ongoing needs of many working Americans, and reforms—small and large—are urgently needed.

*Assistant Professor of Business Law and Ethics, Kelley School of Business, Indiana University— Bloomington.

** Professor of Law, Joseph F. Rice School of Law, University of South Carolina. For helpful comments and discussion, the authors thank Jordan Barry, Michael Doran, members of the Covington & Burling LLP Employee Benefits and Executive Compensation group, as well as participants in the Association of Midcareer Tax Professors 2022 meeting at University of North Carolina School of Law, the 2022 Critical Tax Conference, the Big Ten & Friends Workshop, the 2022 Junior Tax Scholars conference, the University of South Carolina Rice School of Law Junior Faculty Workshop, the Pepperdine Caruso School of Law Tax Policy Workshop, the Georgetown University Law Center Tax Law & Public Finance Workshop, and the UC Law SF Center on Tax Law Speaker Series. We also thank Rich Sheedy for research assistance and Ashley Alvarado and Vanessa McQuinn for their editing assistance. All errors are our own.

Penalizing Precarity

Introduction

I. 401(k) Plans in Context

II. The Gap Between Hardship Distributions andEarly Withdrawal Penalties

A. Who Falls into the Gap

B. How and Why They Fall

1. Permissive Hardship Distributions

2. Limited Early Withdrawal Penalty Waivers

C. Recent Modifications

III. Bridging the Gap for the Most Financially Precarious

A. Harmonizing the Two Regimes

B. Vocabulary and Guidance

C. Withholding Rules

D. Low-Income Loans

E. Simplification

IV. The Broader Challenge of Financial Precarity

A. The Economic Realities of Lower-Income Workers

B. Basic Needs and Emergency Savings

C. Strengthening Social Security

Conclusion

II. The Gap Between Hardship Distributions and
Early Withdrawal Penalties