Retirement accounts are designed to provide financial security for the future, but a growing number of Americans are using them to pay for emergencies today.

“We’ve been seeing a steady increase in early withdrawals over the last five years or so,” says Kirsten Hunter Peterson, vice president of thought leadership at Fidelity Investments, one of the largest providers of retirement plans. According to company data, the number of Fidelity plan participants who took a hardship withdrawal more than tripled from 2018 to 2023.

Hardship withdrawals — early distributions from retirement accounts to meet what the IRS terms an “immediate and heavy financial need” — don’t just slow the growth of your nest egg. The money is taxed as income when you take it out, and in most cases incurs an additional tax penalty.

Moves by Congress in recent years to relax some of the rules around hardship withdrawals may be contributing to the increase in people taking them, Hunter Peterson says, but she sees a bigger factor at play.

“People just don’t have enough short-term savings or emergency savings,” she says. “Many of them are looking to the only source of savings they might have, which is their retirement plan, when an unexpected expense comes up.”

But Congress has also taken steps aimed at addressing this emergency-savings gap, enacting rule changes that could help many people already saving for retirement at work to save for a rainy day at the same time.

Most could not meet $1,000 emergency

The need is acute. Fewer than half of U.S. adults — 44 percent — say they could cover an unexpected $1,000 expense from their regular savings, according to a January Bankrate survey.

“We asked people essentially what’s causing them to save less, and the number one answer in our survey was inflation,” says Mark Hamrick, senior economic analyst for Bankrate. Rising interest rates that can increase debt payments were another factor cited by many respondents.

But taking money out of a 401(k) plan or individual retirement account (IRA) to tide you over comes at a cost. If you haven’t reached age 59½, the IRS will likely assess a 10 percent penalty on the amount you withdraw. That’s on top of the federal and state taxes you would already owe.

There are some exceptions. For example, the IRS may waive the penalty if you need the money to cover costs associated with a birth or adoption, a funeral, or damage from a natural disaster. But you’ll still owe regular taxes, and the money you withdraw is no longer invested and growing from returns and compound interest. That means less of a nest egg when you retire.

There are emotional consequences, too. When people don’t have enough short-term savings to handle emergencies, Hunter Peterson says, they’re more likely to stress over their future finances as well as the current crunch.

A SECURE 2.0 solution at work?

Congress recognized the link between present-day emergencies and future financial security in the SECURE 2.0 Act of 2022, a law aimed at helping Americans save more for retirement that includes a provision explicitly addressing short-term savings.

SECURE 2.0 authorized workplace retirement plans to incorporate a new feature called a pension-linked emergency savings account, or PLESA. Starting this year, employers can enroll workers who participate in a retirement plan in a PLESA as well, funneling payroll deductions into rainy day accounts workers can tap for unexpected expenses, with no tax penalty for early withdrawals.

Here are some of the key rules governing how these plans work.

Employers with a PLESA can automatically enroll you at a contribution rate of up to 3 percent of your pay, but you can opt out.
Contributions stop when the account reaches a predetermined amount. The federal limit is $2,500, but employers can set a lower cap.
“Highly compensated” employees — defined as those who earned at least $150,000 in the previous year — are not eligible. The salary level is indexed to inflation.
Employers can match a portion of your PLESA contributions, but the match is deposited in your retirement account rather than the emergency savings account.

Along with the tangible benefit of helping employees save more, PLESAs also could raise awareness of the importance of having an emergency fund, Hamrick says.

“The messaging around spending is significantly louder than the messaging around saving,” he says. “There is an opportunity here for employers to help to educate more people about not only the opportunity to save for emergencies, but ultimately the need to do that.”

A good time to save

The PLESA provision only took effect Jan. 1, so it’s still too early to tell if it will catch on with employers. Some are taking a wait-and-see approach, says Craig Copeland, director of wealth benefits research for the Employee Benefit Research Institute. There are lingering regulatory questions around the accounts, he says, and some workplaces “are holding off offering them until they really know how they should design them based upon that regulatory guidance.”

However, there is a lot of enthusiasm for helping workers better manage their finances and save for short-term needs, Copeland adds, noting that some companies are offering workers emergency-savings options that are separate from their retirement accounts and don’t fall under the PLESA umbrella.

For example, Delta Air Lines is offering employees financial coaching and the opportunity to open an emergency savings account and have money automatically deposited from each paycheck. Amazon also gives employees an option to direct a portion of their paycheck into a rainy day account. Unlike with PLESA accounts, Delta and Amazon offer this benefit to all workers, not just lower earners.

Whether it comes through your employer or a personal account, building up an emergency fund is one of the best ways to keep on a stable financial footing, advisers say.

Some people are intimidated by the standard suggestion to maintain emergency savings equaling three to six months of regular expenses, but anything you can put away is better than nothing, says Kristen Holt, president and chief executive officer of GreenPath Financial Wellness, a national nonprofit financial counseling organization.

“Even if you don’t have the full $1,000 or three months of savings, you’re still going to be better off if you start with something,” she says.

Increasing your emergency savings could be particularly fruitful right now. Due to the Federal Reserve’s policy of fighting inflation by raising interest rates, “returns on savings are elevated to levels that haven’t been seen for a good number of years,” Hamrick points out, with some bank certificates of deposit (CDs) paying 5 percent or more.

“We all need to be able to walk and chew gum at the same time with respect to personal finances, and that really speaks to the need to save for emergencies, to save for retirement and to pay down debt,” he says. “There is an opportunity to do those things, given the relative stability and strength of the U.S. economy.”

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