Retirement vs Emergency Fund?

Follow us on Twitter!

I got a question recently from a reader named Mike. He’d heard that it was better to go ahead and divert the bulk of your savings to your retirement instead of your emergency fund. He figured that it would be better to chance it and earn perhaps 10% on his retirement than to keep an emergency fund and have it earn less than 1%. Great question, and if you look at it, the math works out better keeping your money in a retirement fund. My thoughts, though, are that an emergency fund is very important and by definition should be something you keep separate and readily available.200236712-001

What it would look like without an emergency fund
Well personally, I wouldn’t sleep as well at night. It is a great feeling knowing that I’ve got 6 months of expenses stashed way in a bank account that I can’t easily access, but could quickly get to in times of an emergency. If instead of keeping that money in a separate ’emergency fund’ I put it in my 401(k) plan or IRA, in theory I’d earn a much better return on my money. My retirement fund has earned 12% this year. My emergency fund has earned 0.04% this year. I could clearly do a lot better keeping it a retirement fund.

When the inevitable happens
However, let’s assume a real emergency comes around and I need to access my money, this time from my retirement fund. There are certain penalty-free times that you can withdrawal from your retirement and an ’emergency’ isn’t one of them. You’d have to fill out several forms and work with your retirement brokerage firm before taking the money out. And then when you finally get a hold of your money, you’d find yourself slapped with a penalty (around 10%) and then you’d of course have to pay some hefty taxes on it. The government gives you tax benefits for setting aside money for your retirement, so they certainly don’t like it when people take the money out before their retirement – it defeats the purpose. The government therefore imposes financial penalties to discourage people from doing so. In the end you’ve got your money, but it’s been a headache and you’ve had to pay some taxes to the government.

Bottom line
You may sit down and do the math though and find that, even with the penalty and the hassle, it still makes more fiscal sense to put your emergency fund money into your retirement rather than keeping it separate. Sure, you might be right. I still stick to my principles, though, and here’s why. Keeping an emergency fund is more than just making money off of your money. An emergency fund should be 3-6 months of expenses set aside, just out of reach. It’s more of a psychological account, less of an earn-interest account. Having an emergency fund set aside gives you the peace of mind to take calculated risks with your other money. It allows you to invest with confidence knowing that if things went south in your life or in the economy, that you’d still be ok. There are too many temptations when your emergency fund money isn’t actually in your ‘emergency fund.’ (“Ah, I could scale back my retirement savings to buy this new car or pay for this vacation.”) Nope, get that attitude out of here. An emergency fund should be tucked away safe and sound.

When you’re starting out, my advice is to work on an emergency fund and your retirement fund simultaneously, but definitely do work on your emergency fund. Once you’ve got it stocked at 3-6 months or to a point where you feel comfortable, by all means go full steam ahead for retirement savings.

Hope you enjoyed the article! Please consider sharing with friends, sharing is caring. Here are some others you might enjoy!
How should I invest my retirement?
3 Things you can do to create wealth today
The Right Percentages

3 Responses

  1. Best article I’ve read on this site so far! Keep up the good work @youngmonfinance! -Dave

  2. I think the emergency fund is vital. If you have to touch your 401K for any reason it can cost you, not only in early withdraw penalties, but in the compounding that money will do over your working career. I did some math and if I took $10,000 out of my 401k now (i’m 28) it would cost me over 100K to my ending retirement balance! Having an emergency fund means you don’t have to touch that 401k until retirement, which is worth more than the 9% extra return you get for taking that large risk.

  3. I have a good friend who keeps a partial amount of his emergency fund in T bills. I thought it was a genius way of keeping the money separate from his bank. I did the same thing. Nice too earn a little interest as well.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.