Balancing Emergency Savings With Retirement Goals
Many people are forced to draw on retirement savings early to handle a financial emergency.
Whether it's saving for retirement, to purchase a house or just to be prepared for an emergency, stockpiling cash is not an easy task for most of us. Unfortunately, that often puts people in difficult situations when an urgent financial need does arise. According to a survey and report from Pew Charitable Trusts, some 13 percent of people with retirement accounts said they had taken an early withdrawal from those funds in the last year to pay for an emergency. But in the way most retirement accounts are designed, this action probably resulted in much higher costs than if the respondents had cash savings to tap into.
"Early withdrawals from retirement accounts come with stiff penalties."
Individual retirement accounts or employer-sponsored 401(k) plans do allow users to withdraw some of what they have invested before they reach retirement age. However, these often come with some stiff penalties. Early withdrawal rules for a 401(k), for example, require that the account holder pay income taxes on that money (which would otherwise be tax-deductible) as well as an additional 10 percent penalty. It's also possible to take out a loan from your own 401(k), but this will incur tax penalties as well as interest fees.
Even for retirement accounts that allow for greater flexibility, early withdrawals still end up costing money in the form of missed investment earnings. Since most retirement funds are invested in the stock market or other financial instruments, any money that's not saved in the account will not earn any interest. That can mean missing out on short-term surges in market value, and even result in a balance that misses the mark when it's time to actually retire.
Still, there are situations in which taking an early withdrawal or asking for a loan is preferable to other options. If the money is used to pay for a lifesaving medical procedure or to save a mortgage borrower from foreclosure, borrowing from retirement savings will usually be easier and cheaper than taking out an unsecured loan like a payday loan or title loan. However, it helps to be aware of other options for covering emergency expenses in advance of actually facing a personal financial crisis.
Building an emergency fund
The best alternative to using nest egg funds to pay for an emergency is, of course, to build up sizeable cash savings. A standard savings account offered by your current bank is often the most sensible option. Financial experts who spoke with The New York Times advised anyone earning an income to start an emergency fund and contribute to it regularly. Start small and try to save the equivalent of one paycheck, then work toward a full month of living expenses and beyond, if possible. According to the Pew survey, the typical household that experienced a financial emergency in the last year said that event cost them around $2,000.
Financial advisors also cautioned against saving too much, in a way. For those who are contributing to retirement investments but find their cash savings lacking, it might be wise to reduce what is being saved for retirement and increase what's going into their bank account. 401(k) contributors who can earn a match on their savings should try to contribute just enough to earn the match, then focus on building up cash savings until they have a comfortable cushion.
Perhaps the last resort before seeking out a loan or withdrawing from retirement savings is a payroll advance. Companies often have policies for granting paycheck advances to employees, but they usually only offer a small portion of future wages and come with many stipulations. Employers may decide to forbid advances entirely, since they come with a host of complications for everyone involved. However, The New York Times did note that some companies have begun partnerships with financial services that streamline the process of obtaining a paycheck advance.
No matter how you are saving for retirement, balancing long-term goals with short-term safety is often a challenge. Don't be afraid to seek assistance from a professional for this and any other concern regarding savings and investment.