Save to Retirement Fund or Emergency Fund?

April 3rd, 2008  |  Published in Retirement  |  5 Comments

If you’re just starting out, you may be put to the decision of whether you should fund your retirement accounts or fund your emergency fund. In order to answer this question, you need to have a grasp of your total financial picture and you can do so by asking yourself the a few questions.

Does your employer offer a 401(k) match? If your employer offers a 401(k) but does not offer a match, the smart money would likely fund the emergency fund first. If your employer does offer a match, contribute as little as you need to in order to receive the maximum match. If your employer gives you 50 cents on the dollar up to 6% of your salary, contribute 6%. Then you should put additional savings into an emergency fund.

It seems like the only question you need to ask yourself is whether the employer offers a match right? Wrong, that’s just the first question. After you achieve the maximum match, you can’t really screw yourself up too much because you’ve already gotten the low hanging fruit.

How much should you put in an emergency fund? The advice generally ranges from 3 months to a year of expenses but I recommend hedging your bets at around six months and then moving funds into a Roth IRA if you are eligible. If not, the 401(k) may be a good second place.

Usually emergency funds are designed to handle events that are less than or equally catastrophic than a job loss, hence the metric of using expenses as a gauge. For events that are more catastrophic, such as a medical emergency, should be taken care of by your insurance coverages (if they aren’t, you should get some insurance). So, six months is a good mean period to be out of work if you’re let go, assuming you get zero severance, because you give yourself ample time to 1) find an equally paying job; 2) cut expenses to compensate for loss of income; 3) find a lesser paying job to cut the drain on your emergency fund.

Have you fully funded your 401(k) and IRA? If so, consider boosting your emergency fund to a full twelve months and then start laddering them in certificates of deposit so you’re getting more than a piddly 0.5% (or less) in interest. This will ensure you have access to a month’s worth of fund (or more depending on how you ladder them) to cover any emergencies you do face. If you do lose your job, the CDs will mature in time for you to need them. If you encounter a major event that’s more than a month’s expenses, you can always float yourself the funds via a credit card.

  

Responses

  1. Paul Petillo says:

    April 4th, 2008 at 8:43 am (#)

    Good advice but if I may add a few things to it. Most folks fail to enroll in a 401(k) because the match is either so small or non-existent that they assume it is not worth the effort. It is. match or no match. Finding the right contribution to those plans is more difficult. Just starting out (no matter what your age) and need your income, shoot for five percent and tweak it until you hit the right take home pay. This is pre-tax and you never see it until you need it, years down the road.

    That emergency fund is much more difficult to determine and while most finance folks suggest six months, that is usually based on current working expenditures and not the seriously downgraded life without work. I have found most people I have spoken with confident in their resourcefulness during times of crisis.

    If they can put $25 a week or $100 a month into an account – a money market fund with limited check writing privileges would be better than tying the cash up in CDs, and increasing those contributions with every pay raise you receive or any bonuses such as tax refunds, it will build quickly and somewhat painlessly.

    And speaking of tax issues, especially around this time of year – if your refund is well over $500, you need to adjust your withdrawals. You are leaving good money in the hands of the people who offer you no interest and no protection from inflation.

    And one last thought: floating the funds via a credit card is how many folks get into trouble in the first place. Focusing instead on living low(er) now and stopping those unnecessary leaks in everyday life such as fees and debt service costs. You will, without a doubt free up much more cash to get those emergency funds funded and that retirement plan rolling.

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