Using Retirement Account Features for Short-Term Savings
March 23, 2022
Using Retirement Account Features for Short-Term Savings
Introduction
individuals may be able to access these savings prior to
Workers can often use retirement savings for unexpected
retirement by making withdrawals for specified hardship
expenses. However, policymakers have expressed an
reasons or by borrowing from the account. A Plan Sponsor
interest in helping workers save for emergencies in ways
Council of America (PSCA) survey indicated that 91.7% of
that do not draw down their retirement assets. Employer-
profit sharing and 401(k) plans in its survey permitted
sponsored defined contribution (DC) plans—which
hardship distributions, and 83.9% of plans permitted loans
facilitate long-term savings—could serve as a platform for
in plan year 2020. Individuals who take hardship
workers saving for unexpected expenses. In DC plans—of
withdrawals from DC plans face a 10% penalty on the
which the 401(k) plan is the most common—employees
amount withdrawn unless an exception applies. A loan
and/or employers contribute to employees’ individual
repaid in full by the plan-specified deadline is not subject to
accounts in the plan. Some proposals to increase short-term
the 10% penalty.
savings envision new add-on accounts (informally referred
to as sidecar accounts in some cases; e.g., see S. 2601 in the
Most DC plan participants do not withdraw funds from
117th Congress). Other proposals would use existing
their accounts in a given year. The Investment Company
features of employer-sponsored DC plans that allow funds
Institute found that in each year from 2008 through 2020,
to be used for unexpected expenses. This In Focus discusses
fewer than 2% of DC plan participants took hardship
two of such existing features: deemed Roth Individual
distributions. At year-end 2020, 14.8% of DC plan
Retirement Accounts (IRAs) and after-tax accounts (non-
participants had outstanding loans (similar to prior years).
Roth) within qualified retirement plans.
Using Current Retirement Account
Retirement Savings Accounts
Features for Short-Term Savings
Workers may be able to make one or more of the following
The following sections describe two current features of
types of contributions to their DC plans:
retirement plans that could be used as a platform for short-
term savings: deemed Roth IRAs and after-tax accounts in
Pre-tax contributions lower an individual’s taxable
qualified DC plans. Proposals discussing these features note
income at the time of contribution. Withdrawals of
that modifications regarding withdrawal frequency or
savings (i.e., contributions and any investment earnings)
account balance restrictions might be necessary.
attributable to pre-tax contributions are included in
taxable income at the time of withdrawal.
Deemed Roth IRAs
IRAs are tax-advantaged accounts most commonly used by
Designated Roth account contributions do not lower
workers to save for retirement outside of the workplace.
taxable income. Qualified withdrawals—which may
However, P.L. 107-16 permitted qualified employer-
include earnings—from designated Roth accounts are
sponsored DC plans to allow employees to make voluntary
not included in taxable income when withdrawn.
contributions to separate accounts designated as traditional
or Roth deemed IRAs. Deemed IRAs follow the same
After-tax (non-Roth) contributions (hereinafter, “after-
contribution and withdrawal rules as their traditional or
tax contributions”) do not lower taxable income.
Roth IRA counterparts (26 C.F.R. §1.408(q)-1).
Withdrawals attributable to after-tax contributions are
Withdrawals from Roth IRAs are made in a specified order:
not included in taxable income, whereas investment
first, from regular contributions; second, from conversion
earnings attributable to those contributions are included
and rollover contributions (i.e., transfers from employer-
in taxable income.
sponsored plans and other IRAs); and third, from earnings
on contributions. Because amounts attributable to regular
An individual’s pre-tax and designated Roth account
contributions may be withdrawn tax- and penalty-free from
contributions (called elective deferrals) cannot exceed
Roth IRAs, they could possibly function for short-term
$20,500 ($27,000 for individuals age 50 and older) in 2022.
savings.
After-tax contributions are not subject to the elective
deferral limit. However, total contributions (which include
A potential limiting factor in using deemed Roth IRAs for
elective deferrals, employer contributions, and any after-tax
short-term savings is that DC plans must pass annual
contributions) cannot exceed $61,000 ($67,500 for
nondiscrimination testing, which ensures that pension plans
individuals age 50 and older) in 2022.
benefit many workers rather than just highly compensated
employees (HCEs). If non-HCEs were to contribute more to
In 2021, 65% of private sector workers had access to, and
their deemed Roth IRAs and proportionately less to their
47% participated in, DC plans. Though Congress intended
pre-tax accounts or designated Roth accounts relative to
for DC plan savings to be used for retirement expenses,
HCEs, the plan might be more likely to fail a
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Using Retirement Account Features for Short-Term Savings
nondiscrimination test called the actual deferral percentage
Retirement account features used for short-term savings
(ADP) test (which compares elective deferrals of HCEs and
could assist these households that have both DC plans and
non-HCEs).
low levels of liquid savings to save more. However, many
households with low levels of liquid savings did not have a
After-Tax (Non-Roth) Accounts in Qualified DC
DC plan at their current jobs.
Plans
After-tax accounts in qualified DC plans could also
Figure 1. Household Liquid Savings Based on Defined
function as a structure for short-term savings. One reason is
Contribution Plan Coverage at Current Job, in 2019
because withdrawals can be taken at any time if the plan
For Households in Which the Head of Household or Spouse
allows. However, the pro-rata rule could limit their use for
Was in the Labor Force
short-term savings because taxation and possible penalties
may increase the cost of accessing funds. Unlike
withdrawals from Roth IRAs—in which non-taxable
amounts attributable to contributions and conversions can
be withdrawn prior to any taxable amounts (such as early
withdrawals of earnings)—withdrawals from qualified DC
plans that include after-tax contributions must be
proportional between pre-tax and after-tax balances
(referred to as the pro-rata rule; 26 U.S.C. §72(e)(8)). This
means that while withdrawals of after-tax contributions are
tax- and penalty-free, earnings based on these
contributions, if any, are taxable and may be subject to a
10% penalty unless an exception applies. For example, an
individual who withdraws $100 from his or her $500 after-
tax account ($450 of contributions and $50 of pre-tax
earnings) would take $90 of the withdrawal from
contributions and $10 from earnings. The $10 in earnings
may be subject to tax and a 10% penalty. An exception to
the pro-rata rule applies for after-tax contributions made
before 1987.
Another potential limiting factor in the use of after-tax
accounts is related to nondiscrimination testing. As
described in the deemed Roth IRA section, if non-HCEs in
a plan were to contribute more to their after-tax accounts
and proportionately less to their pre-tax accounts or
designated Roth accounts than HCEs did, the plan might be
Source: CRS analysis of the 2019 Survey of Consumer Finances.
more likely to fail the ADP nondiscrimination test.
Notes: Liquid savings include checking, savings, money market
However, another test—the actual contribution percentage
accounts, call accounts, and prepaid cards. In 2019, there were 128.6
(ACP) test—compares the average percentage of after-tax
million households; 97.1 million had a household head and/or spouse
contributions and employer matching contributions as a
in the labor force.
proportion of compensation between HCEs and non-HCEs.
Additional non-HCEs making after-tax contributions
Existing state automatic IRA programs most commonly set
relative to HCEs could assist plans in passing the ACP test.
up Roth IRAs for individuals without access to a workplace
plan. Because the likelihood of access to an employer-
A PSCA survey indicated that 19.9% of profit sharing and
sponsored plan increases with a worker’s wage or salary,
401(k) plans in its survey permitted after-tax contributions
the state IRA programs may have a large number of
in plan year 2020.
workers who might benefit from short-term savings
Discussion
accounts attached to retirement plans. Research on state
automatic IRA programs could examine whether
Behavioral economists note that the availability of separate
participants use their Roth IRAs for short-term savings
accounts for short- and long-term savings may facilitate
needs.
household financial decisionmaking (what is called mental
accounting). In addition, more individuals might choose to
For Further Information:
participate in (or contribute more to) their retirement plans
John Beshears et al., “Building Emergency Savings through
if they had the opportunity to save for emergencies in
Employer-Sponsored Rainy-Day Savings Accounts,” Tax
designated accounts.
Policy and the Economy, vol. 34, no. 1 (2020), pp. 43-90.
Figure 1 provides data on the number of households with a
CRS Report RL34397, Traditional and Roth Individual
head of household or spouse in the labor force, with and
Retirement Accounts (IRAs): A Primer.
without DC plans at their current jobs, based on the amount
of reported liquid savings (checking, savings, money
market accounts, call accounts, and prepaid cards) in 2019.
Elizabeth A. Myers, Analyst in Income Security
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Using Retirement Account Features for Short-Term Savings
IF12065
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https://crsreports.congress.gov | IF12065 · VERSION 1 · NEW