Report Offers Considerations for Using Retirement Plans to Help With Emergency Savings

Roth and after-tax accounts could be used to facilitate emergency savings, with certain considerations about the cost of accessing funds and the effect on nondiscrimination testing.

A report from the Congressional Research Service describes how defined contribution plans can be used to help employees build emergency savings.

It notes there are two current features of retirement plans that could be used as a platform for short-term savings: deemed Roth individual retirement accounts and after-tax accounts in qualified DC plans. The proposals discussing these features note that modifications regarding withdrawal frequency or account balance restrictions might be necessary.

CRS points out that the Economic Growth and Tax Relief Reconciliation Act of 2001 permitted qualified employer-sponsored DC plans to allow employees to make voluntary contributions to separate accounts designated as traditional or Roth deemed IRAs. “Because amounts attributable to regular contributions may be withdrawn tax- and penalty-free from Roth IRAs, they could possibly function for short-term savings,” the report says.

In addition, CRS suggests, after-tax accounts in qualified DC plans could also function as a structure for short-term savings. Withdrawals from after-tax accounts can be taken at any time if the plan allows. However, the report notes, the pro-rata rule for taking withdrawals from these accounts could limit their use for 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“Unlike withdrawals from Roth IRAs—in which non-taxable amounts attributable to contributions and conversions can be withdrawn prior to any taxable amounts (such as early withdrawals of earnings)—withdrawals from qualified DC plans that include after-tax contributions must be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,” the report explains. “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.”

CRS notes that plan sponsors considering the use of these options for helping employees build emergency savings should take into consideration the potential effects on nondiscrimination testing.

“Behavioral economists note that the availability of separate accounts for short- and long-term savings may facilitate household financial decision making,” the report states. “In addition, more individuals might choose to participate in (or contribute more to) their retirement plans if they had the opportunity to save for emergencies in designated accounts.”

However, CRS says, while these retirement account features could help households that have both DC plans and low levels of liquid savings to save more, data shows that many households with low levels of liquid savings are not offered a DC plan at their current jobs.

Lawmakers are also considering ways the retirement plan industry can help employees with emergency savings. Representatives Brad Wenstrup, R-Ohio, and Tom Suozzi, D-New York, have introduced the Enhancing Emergency and Retirement Savings Act of 2022. This bill seeks to help more Americans save for retirement by providing greater flexibility to cover unexpected financial emergencies, according to a statement released by Wenstrup.

The bill would allow penalty-free emergency distributions of up to $1,000 from tax-exempt retirement plans for emergency expenses. Plan participants would be limited to one such distribution in a calendar year and would be unable to access another emergency distribution before having paid off their first, thereby safeguarding long-term savings, according to Wenstrup.