Stop using retirement accounts as emergency funds

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Building an emergency fund might just keep your retirement plans on track.

Americans have been putting more into their retirement accounts, with 21 percent of workers saying they are saving more than they were last year, according to a recent survey. Despite market volatility, 401(k) balances are up almost 2 percent from the first quarter, according to Fidelity data, to an average $88,900. Over the same period, average balances for long-term millennial savers rose to a record high of $92,900.

But not all savers are able to keep up the momentum.

One in 10 workers has taken a hardship withdrawal from a retirement account, according to the FINRA Investor Education Foundation's recent National Financial Capability Study of 27,564 adults. Another 13 percent have borrowed from retirement savings. (See chart below for a breakdown.)

The leading reasons for borrowing? "Unplanned, major expenses" and credit-card debt, each of which account for 23 percent, according to a 2015 survey of 4,550 adults in the workforce by Transamerica Center for Retirement Studies. Top reasons for hardship withdrawals include medical expenses and payments to prevent eviction from a residence. (See charts below.)

"The reasons people take them suggest they lack emergency savings," said Catherine Collinson, president of the Transamerica center. "Unfortunately, a plan loan may be their best alternative or their last resort."

Borrowing from your retirement account can seem like a decent option — interest rates tend to be low, and you're borrowing from, and paying interest to, yourself. Under the right circumstances, it can be a smart strategy for investments such as buying a home or covering college tuition so you can land a higher-paying job, said certified financial planner Sheryl Garrett, founder of The Garrett Planning Network.

"I'm open-minded to the potential, but once we run the good and bad, often it doesn't work out," she said. "It's not a slam-dunk answer."

That's because tapping retirement accounts early carries plenty of risk.

"For me, plan loans are a wolf in sheep's clothing," said Collinson.

The first consideration: Will you be able to pay back the money?

Plan loans tend to be small. The median outstanding loan amount in 401(k) plans at the end of 2014 (the most recent year available) was $4,239, according to a briefing from the Employee Benefit Research Institute. But half of Americans say they don't have adequate emergency savings to cover an expense of even $400, according to 2015 Federal Reserve data. If you're among them, that's still extra money to come up with to cover loan payments — or, if you leave your job, the entire outstanding balance due.

If you fail to repay the loan according to the plan terms, it becomes a taxable distribution, said Garrett. Many borrowers will also face a 10 percent early-withdrawal penalty.

Borrowing from a retirement account may also jeopardize retirement prospects.

"It's always with the disclosure of: 'You may have just set yourself back a few years in retirement,'" said certified financial planner Erin Durkin, director of client planning for EP Wealth Advisors.

Although you pay interest to yourself, that's not the same as investment growth the borrowed funds might have generated, she said. Plus, your account may not be growing from new contributions.

"When people take a loan, they typically stop saving," said Collinson. "They can't afford to pay back the loan and continue [regular contributions] at the same time."

That savings gap may require bigger contributions down the line to get back on track. A middle-income household needs to save 15 percent into retirement savings each year to generate enough income in retirement, according to a 2014 study from the Center for Retirement Research at Boston College. Among middle-income workers falling short, those ages 30 to 39 need to increase contributions by an average 7 percentage points, those ages 40 to 49, 13 percentage points and those ages 50 to 59, 29 percentage points.