Financial advisors suggest maintaining an emergency savings fund ranging from three to six months of non-discretionary expenses. Having a set amount set aside for emergencies protects your retirement savings, and helps you avoid going into serious debt when a fiscal crisis occurs. While it may be emotionally difficult to keep money in a liquid (read: not high-yielding account), having the money easily accessible in case of need is crucial.
Can’t retirement savings be considered an emergency fund?
Some believe that an emergency fund is a waste of time and money, as they figure they could always access their retirement funds in an emergency. However, there are two reasons that make tapping into retirement funds for emergencies a bad idea.
First, there are often tax penalties for withdrawing money from retirement funds. The tax-free incentives are meant to encourage savings, so the government discourages withdrawing from these accounts by charging stiff penalties to the tune of 10% plus tax. You may also be tempted to borrow against your retirement plan, but depending on the terms of the program, the cost of borrowing against your retirement funds can be quite high. Anyway, do you really want to put money into an account and then pay interest for the privilege of borrowing back your own money?
Second, if you withdraw money from retirement funds for emergencies, will you really repay it? Most people repay money they owe to someone else quicker than repaying themselves. Over time, not repaying withdrawals can have a serious impact on the size of your retirement fund.
Pre- or post-retirement
Creating an emergency fund protects your retirement savings. Make sure the emergency fund is liquid, so you can use it if necessary. The emergency fund protects you both pre- and post-retirement. By having money readily available, you won’t need to withdraw your principal, upon which your future income may rely.
What constitutes an emergency?
Use your emergency fund wisely. Buying a new couch is not an emergency. Paying bills in case of disability or unemployment is. Some areas, like a financing a new washing machine or major auto repairs fall into a gray area. Consider creating an un-emergency fund for periodic, expected expenses like these.
For more information about emergency funds, click here.
Douglas Goldstein, CFP®, is the Director of Profile Investment Service, Ltd., which specializes in helping people who live in Israel with their US dollar assets and American investment and retirement accounts. He helps olim meet their financial goals through asset allocation, financial planning, and using money managers.
Published October 27, 2014.