Associate Professor Damon Jones

In a new paper, Associate Professor Damon Jones studies the effects of early-withdrawal penalties on retirement savings accounts. The paper reports individuals’ withdrawal behavior from before and after they turn 59½ (the age at which the penalty expires) to see whether the presence of a penalty impacts the amounts people withdraw.

Jones, alongside coauthors Gopi Shah Goda from Stanford University and NBER and Shanthi Ramnath from the Federal Reserve Bank of Chicago, was interested in three key behaviors: short-term increase in withdrawals after passing 59½, long-term increase in average withdrawals, and a decrease in withdrawals just before 59½, potentially in anticipation of the penalty passing.

Using tax records from the years 1999 to 2013 from individuals born between July 1, 1941 and July 1, 1951, the researchers looked at withdrawal patterns in the weeks and months surrounding a person’s critical 59½ milestone.

Their research returned several interesting results:

  • In the short run, withdrawals increased three to three-and-a-half times the usual baseline
  • After thirty days, the increase leveled out for the long run to double what it was before the person turned 59½
  • During the days leading up to the milestone, no evidence of anticipatory reductions was found

“The withdrawal patterns differed depending on people’s circumstances. For example, the short run increase was greater for those who turned 59½ during the great recession or personal periods of financial hardship,” said Jones. “On the other hand, the increase was less dramatic for those who receive disability insurance payments, possibly because those individuals can qualify for penalty waivers.”

This study comes as the number of people withdrawing from retirement accounts prematurely due to hardship (called a “hardship withdrawal”) hit an all-time high due to the financial strain of inflation. It also comes around the same time as Congress’s recent effort to reform the penalties —including the 10% fee—imposed for taking money out early.

Until the “Secure 2.0” reforms recently passed by Congress, most withdrawals before the age of 59½ were subject to a 10% penalty unless the individual qualified for a “hardship exemption” to waive the penalty. The recent policy allows for a once-a-year withdrawal of $1,000 for an expanded set of emergencies, without having to pay the 10% penalty.

Jones and his co-authors consider how policies such as those in “Secure 2.0” that help savers avoid early withdrawal penalties impact both savings and government tax revenue.

First, they looked at adjusting the age at which the penalty expires by shifting it to one year earlier. They found that penalty revenue lost in the year after shifting from 59½ to 58½ was “a transfer from the government to the savers, and the additional behavioral responses result in fewer tax expenditures on tax-preferred savings,” which resulted in an overall tax revenue increase.

Second, they considered a penalty holiday, a temporary pause in enforcing the early withdrawal penalty.  In this case, they reported that “the savings from a decrease in deferred earnings more than pays for the loss of early withdrawal penalties.”

Both policies had a positive impact using their calculations for the marginal value of public funds, said Jones. “Those who make the early withdrawals have the liquidity they need without paying a penalty and the policies overall increase tax revenue. There could be a downside for people who have trouble saving for retirement. Relaxing the early withdrawal penalty could result in those households regretting having taken too much out of their savings account. The fact that Secure 2.0 places a cap on the amount taken out for emergencies could hedge against this risk, although determining whether $1,000 is the right amount was beyond the scope of our paper.”