Obama’s Economic Rescue Plan Would Allow Penalty-Free Withdrawals up to $10,000 This Year and Next From Retirement Accounts

By Jeremy on Oct 14, 2008 with Comments 73

Is Obama’s Plan to Let People Tap Into Their Retirement Plan a Good Idea?

I don’t discuss politics on this site, and for good reason. It always seems to bring out the ugly side of people when a heated debate starts. I would rather talk about things from a pure financial standpoint and keep politics out of it, but something came across my news feed this morning that really caught my eye. When reading a headline about Obama’s economic rescue plan, I saw that one of the components of the plan would be to allow people to withdraw 15%, up to $10,000 from their retirement plans, this year and next, without penalty. I don’t care what political party proposed this idea, but this is a shortsighted band-aid of a solution that won’t address long-term financial troubles.

UPDATE 02/2009: As of now, the stimulus packages that have gone through and become law do not provide the penalty-free withdrawals that were initially discussed.

Sending the Wrong Message

Suddenly allowing people access to some of their retirement funds without risk of an additional 10% penalty is sending the wrong message to savers. Many people that this economic plan is targeting are those who need retirement savings the most–the working class who are struggling to get by, yet know the importance of saving for retirement. These individuals aren’t typically going to be the ones to amass a few million to fund their retirement, and instead are going to rely on what they have saved to provide just some sort of supplement to Social Security and possibly a small pension. If you give someone an opportunity to wipe out 30% of their retirement account over the next 15 months, you’re just setting them up for having even less in retirement, whether that’s just a few years away or a few decades.

A Backdoor for Generating Tax Revenue

If you notice, this plan only calls for eliminating the 10% early-withdrawal penalty, but guess what. You will still have 20% withheld from your distribution for federal taxes. That’s right, the government would be nice and let you keep that extra 10% you’d otherwise have to pay, but they will gladly collect their tax on the distribution. If you do the math and look at the hundreds of millions that people would begin withdrawing, the government stands to rake in a good chunk of change.

Now, I’m not against the government getting their money. After all, these were tax-deductible contributions that have grown tax-deferred, so they aren’t doing anything wrong. But what I do have an issue with is that this comes across as a wolf in sheep’s clothing. You’re making it very attractive for regular people to suddenly get access to a few thousand dollars of their savings while you quietly rake in taxes that would otherwise be tied up for decades. Factor in the loss of the power of compounding by taking the withdrawal with the taxes they will be paying, and you’re making it a raw deal for the individual.

It Looks Good On Paper

It looks good for voters, but that’s about it. Obviously, everyone is saying whatever they can to try and elicit votes, and at first glance, it’s easy to see why this idea would make sense. In theory, this really would provide some cushion for those who are in a tight spot. The other part of the theory is that only people who are left with no other option would withdraw money from their account. The reality is that if you allow this, even people who aren’t on the brink of foreclosure or in dire straits will tap into their account to take advantage of this “free” money. It would be seen as another stimulus check. So, while some people really could be helped out of a financial bind, there are just as many people who will see this as an opportunity to take the money out when they otherwise wouldn’t have considered it or even had the option to. This will just be a short-term shot in the arm that will put them at a greater disadvantage in the decades ahead when they need to rely on their savings for retirement income.

In addition, most plans also already allow loans and/or hardship withdrawals. Those provisions were put in place for exactly these types of situations, where someone might need real financial help. Not only that, but since over 80% of retirement plans allow loans, people should be seeking a loan first since there is already no penalty or taxes owed as long as you make payments on the loan. In addition, loans typically allow you to borrow up to 50% of your contributions, which may be far more than the proposed 15% or $10,000 suggestion. Even with these provisions in place, I still see people who use them to treat their retirement account like a bank account. So if you offer a period of time where they can take the money without penalty, they surely will.

You Couldn’t Pick a Worse Time

Most people’s accounts are down anywhere from 20-50% over the past year, so selling now to take advantage of this withdrawal would make matters worse. Not only would you be selling at a loss, but you’re going to lose another 20% to taxes. If that’s not a raw deal, I don’t know what is. Some people stand to take a 70% or greater loss on the money they would take out.

Not only that, but this creates more selling in the market. If we started to see a steady flow of people liquidating what part of their retirement plans they can, you’re putting even more pressure on the already battered stock market. They keep telling people not to worry, stay the course, and keep investing, but this plan basically encourages people to take their money out.

What Do You Think?

As I mentioned from the beginning, this doesn’t have anything to do with one political philosophy over another since I’d be equally dissatisfied with this idea if it was presented by another candidate, or a non-partisan academic. I might be a little biased since my line of work has me dealing with retirement plans and their participants, but with the stuff I see every day and the decisions people make within their plan, I know this would be a very bad idea that’s trying to fix a much larger problem. What do you think?

Filed Under: Economy

About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and About.com. Jeremy is also a community editor at Bundle and a regular contributor for other publications such as the U.S. News, Intuit, and American Express. Be sure to follow Jeremy on Twitter.