More people are making hardship withdrawals from their 401(k) accounts, raiding retirement funds to cover emergency medical expenses, or to avoid losing a home.

Hardship withdrawals from Fidelity Investments 401(k) accounts have tripled in five years, according to a report from the investment firm. The share of plan participants withdrawing funds rose from 2.1% in 2018 to 6.9% in 2023.

“It’s a big problem, and it’s a growing problem,” said Kirsten Hunter Peterson, vice president of thought leadership at Fidelity.

Vanguard reports that hardship withdrawals have doubled in a four-year span, from a monthly rate of 2.1 transactions per 1,000 participants in 2018 to 4.3 in 2022.

Americans who tap retirement funds to cover an urgent expense often act out of desperation, investment experts say. They may lack emergency savings and live on too tight a budget to risk taking out a loan.

“What we know is that people will dip into their 401(k) when they don’t have any other savings tool available to them,” Peterson said.

Yet, taking a hardship distribution from a traditional 401(k) plan is far from ideal, financial planners say.

Hardship withdrawals from a 401(k) should be a 'last resort,' experts say

The IRS treats the money as taxable income. You may also face an additional 10% tax penalty for making an early withdrawal from your retirement account. (The IRS publishes a handy list of exceptions to that penalty.) You aren’t allowed to repay the funds, and you will miss out on the compounded interest those dollars might have earned between now and your retirement.

The costs can be steep. Let’s say you have a 401(k) with a $38,000 balance, and you need $15,000 for an unexpected expense. To cover all the taxes, including the 10% penalty, you would have to withdraw a total of $23,810, leaving only $14,190 in your depleted account, according to an example provided by Fidelity.

“We see it as a last resort,” said Andrew Fincher, a certified financial planner in Vienna, Virginia. “It’s not a great place to go.”

The rise in hardship withdrawals comes at a moment when, compared to four or five years ago, many Americans are spending more and saving less.

Workers are saving 3.9% of their disposable income, as of August, compared with 6.6% in August 2018, according to federal data.

Saving money is hard these days, because inflation is up. Annual inflation hit a 40-year high of 9.1% in June 2022. The annual rate eased to 3.7% in September, although that figure remains higher than the Fed's target of 2%. Through much of the past decade, prices rose by 1% or 2% in a typical year.

The nation stockpiled savings amid the COVID-19 pandemic, an era of stay-at-home orders and federal stimulus checks that pushed the national savings rate to historic levels.

That era is over. Today, just under half of American adults have enough emergency savings to cover three months of living expenses, according to a recent report from Bankrate, the personal finance site.

Hardship withdrawals are rising amid nagging inflation, steep interest rates

Experts say the rise in hardship withdrawals reflects a confluence of economic forces, including rising prices, high interest rates, and the end of the pandemic savings binge.

The hardship withdrawal is tailored for workers who face “an immediate and heavy financial need,” according to IRS rules.

You probably can’t take a hardship withdrawal to buy a boat or a home theater system, the IRS says. But you can take one to cover costly medical care, a home purchase, college tuition or funeral expenses, or to prevent foreclosure or eviction. You withdraw only what you need to cover the hardship.

Housing and medical costs are the leading reasons for hardship withdrawals, according to Vanguard data. In 2022, 36% of withdrawals went toward avoiding foreclosure or eviction, and 32% covered medical expenses.

Many financial advisers regard the hardship withdrawal as one of the worst financial moves a worker can make. But some scenarios are even worse.

“If you’re going to be foreclosed out of a house, not getting foreclosed out of a house may be more important than saving for retirement,” said Craig Copeland, director of wealth benefits research at the Employee Benefit Research Institute.

In 2018, Congress eased restrictions on hardship withdrawals for American workers facing dire need. Among other changes, lawmakers removed a requirement for workers to borrow against their 401(k) before taking a hardship withdrawal.

Which is better? Withdrawing from a 401(k) plan, or borrowing against it?

Borrowing against a 401(k) remains a viable alternative to withdrawing funds. Workers may borrow up to half of their account balance, up to a maximum of $50,000, and repay the money through payroll deductions.

More on 401 (k)s:With recession looming, more Americans tap retirement funds for cash. But is it a good idea?

Fincher, the Virginia financial planner, had a client who needed $40,000 to cover an unexpected medical expense.

“They did not have any savings for this. Their insurance was not able to cover what they needed,” he said.

Fincher recommended that the client borrow the funds from their 401(k). When you borrow against a 401(k), you repay the loan, plus interest, to yourself. The interest helps you recover the income you lost by removing the funds from your investment account.

But Fincher’s client chose a hardship withdrawal. That option freed them from large monthly loan payments. Instead, the client increased their 401(k) contributions to restore the lost funds.

The share of Fidelity plan participants who borrowed against their retirement funds dipped from 6.5% in 2018 to 5.7% in 2023. All told, 12.6% of participants borrowed or took hardship withdrawals from their 401(k) plans in 2023, compared to 8.6% in 2018.

“Historically, we have guided people away from taking hardship withdrawals,” said Peterson, of Fidelity. “We generally don’t want folks to dip into their long-term retirement savings to cover everyday or emergency expenses.”

Fidelity has worked with employers, including Whole Foods Market and Starbucks, to offer emergency savings accounts to workers. The initiatives encourage employees to make automatic contributions into personal savings accounts, in much the same way they would fund a 401(k).

“A lot of folks have gotten used to thinking of their retirement savings as their emergency savings,” Peterson said, “because there is no other source of savings available to them.”