Examining Leakage from Retirement Savings Accounts

Pre-retirement withdrawals— often referred to as “leakage” from retirement accounts—are allowed under certain circumstances, subject to certain penalties or additional taxes. The Joint Committee on Taxation (JCT) recently issued a report to Congress summarizing its efforts to better understand contributions to, and distributions from, retirement accounts, with a particular emphasis on distributions from retirement accounts to pre-retirement age individuals.

In “Estimating Leakage from Retirement Savings Accounts,” the JCT examined 16 years of tax returns and information returns. For purposes of this report, the JCT defines leakage as occurring when an individual age 20 to 50 takes DC or IRA distributions that exceed contributions the individual makes to those accounts in the same year. It reports estimates of leakage among working-age individuals and analyzes the extent to which certain common life events contribute to it. 

Job Separation

The JCT staff estimates that roughly 22% of net contributions made by those age 50 or younger leak in a given year; the most prominent factor it associates with that leakage is job separation. The JCT says that the strong correlation between leakage and job separation its staff found is consistent with prior research, and with many features of tax-preferred retirement savings in the United States.

Job separations often prompt employees to make an active decision regarding their retirement assets, the JCT says, which can cause individuals to move some of their assets outside of retirement accounts. For instance, the report notes, job separations can result in lower income, which could result in an individual seeking a  pre-retirement distribution as a source of consumption smoothing. And the likelihood of such a phenomenon could be greater if a separation is unexpected.

An additional source of leakage, the report says, results when an employee separates from service, and the employer forces separating employees with small DC balances ($1,000 or less) to distribute the balance of their account. Such employees have 60 days to roll this amount into an IRA or other eligible retirement plan, the JCT notes, but they say that such a situation still likely results in some leakage. 

Additional Life Events 

The JCT reports that there are other life events that are especially prone to prompting leakage. In ascending order of probability of causing leakage, they are: new tuition, medical expenses, home purchase, divorce and negative income shocks. 

Implications

The JCT says that this analysis has also yielded several pieces of information that will be useful to its staff in making revenue estimates and also useful to retirement policymakers:

• During the Great Recession, retirement distributions did not meaningfully increase for those younger than age 50, but contributions dipped well below the pre-Great Recession trend. 
• While not visible in the tax system, employer contributions are an important source of saving for those younger than age 50. 
• There is a strong correlation between job separations and leakage of assets from designated retirement accounts. “The evidence emphasizing the role of job separations in leakage suggests that rules related to forced distributions and portability of plans likely affect leakage from retirement savings accounts,” says the JCT.