When the inevitable financial emergency strikes, will your retirement suffer? Without easy access to money, the proverbial flat tire, unexpected plumbing issue or hospital visit will set anyone into a scramble for cash. Will you need to borrow from friends and family, go into credit card debt, or take a payday loan? Without other options, financial emergencies can also affect your 401(k) or workplace retirement plan as well. When people are short on money, they stop their 401(k) contributions, take a loan from their retirement plan or a hardship distribution. Setting up and consistently setting aside money in an account with funds for financial emergencies is great in concept, but for many it is just that. You do have an option to save for emergencies (or other non-retirement purposes) at work, all you have to do is ask about it. It’s called a traditional aftertax savings account.
The Challenge
According to a recent study by the Federal Reserve, despite nearly 72% of adults responding they are “doing okay or feeling comfortable” financially, a surprising 40% of respondents would either not be able to cover a $400 unexpected expense or would have to borrow money or sell something to meet it. Think for a minute about how many unexpected things in life cost $400 or more. Whatever the amount of an unexpected financial emergency, if you don’t have the funds pay for it, there will be an impact. Whether it is the cost of high interest payments that comes with carrying credit card debt, figuring out how to pay back friends and family or parting with a cherished asset, they all have an impact.
To date, it hasn’t been “easy” to set up or consistently fund an emergency savings account. First, this account should be harder to get access to than your checking account. As such, you might need to set-up a new account at your bank or even a different bank. Now you have to actually go to the bank, maybe there are added fees, or a certain minimum deposit requirement to open the account. Those reasons alone are enough to delay or deter many. Second, how are you going to set aside money in that account over time? Can you make small contributions every time you get paid, or do you have to make larger one-time deposits? The more obstacles in the path, the odds of completion decline. Despite the best of intentions, some people never get started and place both their short and long term financial plans at risk.
Retirement Impact
After the dust settles from the scramble to cover a financial emergency, some will stop their 401(k) contributions to offset the increase in costs. Pausing retirement plan contributions might not seem like a big deal today, but the impact comes down the road. What makes things worse is if your company has a 401(k) match, the impact is magnified as you won’t get that contribution either. Financial emergencies are also a major reason people take a loan against their retirement account. Much has been written about the issues with 401(k) loans. What doesn’t get talked about as much is that some people have to stop or reduce their retirement contributions to afford their new loan payments. That can be a double whammy impact on their retirement plans. Depending on the type of emergency, they might also decide to apply for a hardship distribution from their retirement account. This can be devastating to someone’s retirement. While they are able to access the funds in their retirement account, what many don’t realize is they still have to pay income taxes on what they withdraw and an additional 10% penalty if they are under age 59.5 at that time. Unlike a 401(k) loan, they don’t have the option to repay the money used to cover the expense back into their account over time. Many of these scenarios can be avoided with a properly funded emergency savings account. Which leads to the inevitable questions, how can you get started and how much is enough?
How To Get Started?
If your employer offers a workplace retirement plan, with a slight change you could start building your emergency savings fund in your 401(k) plan while you save for retirement. Today, most 401(k) or similar plans offer the option to save a portion of your pretax salary for your retirement. Others, will allow you to contribute to a Roth aftertax account as well. What many employers are not aware of, and don’t offer is a “Traditional Aftertax” savings option. Unlike the pretax or Roth options, this contribution option is not exclusively designed for retirement savings. As the name implies, if offered you may set aside money from your paycheck on an aftertax basis, same as if you were to use a checking or savings account for emergency savings. Any interest, dividends or gains you earn accumulate tax deferred. When and if you need to use the money, your principal is returned to you tax free and any increase is value is taxed as income in the year you receive it. There are no restrictions to hold money in this account until retirement age. You also don’t need a specific reason to access the money, unlike hardship distributions from 401(k) plans. For these reasons and more, more employers are exploring this option. Now, onto the other inevitable question.
How Much Is Enough But Not Too Much?
When it comes to emergency savings, something is better than nothing. After that, there is no concrete answer on how much emergency savings you should have. To echo a theme, $400 is a good place to start. Once you have that taken care of, think about emergency savings as how many months of living expenses you could cover. Three months is a great rule of thumb. For retirees, or those approaching retirement who plan to live off of their investments, having between six months or as much as two years of living expenses set aside can provide the flexibility to use your cash to pay expenses in market downturns instead of selling investments in adverse market conditions. Again, something is better than nothing, but the actual amount you need is highly personal.
Ask About It At Work
Saving for an unexpected financial expense could start with the simple step of asking your employer to add the “Traditional Aftertax” option to your workplace retirement plan. The time and cost to set it up is negligible. Be sure to mention this as well: Studies have shown people are 15 times more likely to save if they can do it with the convenience and consistency of payroll deduction. The concept also aligns with the current popular employee benefits trend of financial wellness. Add to it that most employers are looking for new low-cost and valuable options to improve their employee benefits package, and you stand a pretty good chance of your request being taken seriously. Think about it, if you and your fellow employees could easily save for emergencies through payroll deduction that would mean fewer 401(k) loans, fewer people hitting the pause or reset buttons on their retirement savings (and potentially miss out on matching contributions), less financial stress and a happier more productive employees, who could say no to that?
Saving for retirement is a long journey that requires consistency, planning and preparation. Being prepared for an unexpected financial emergency can have a big impact on when you retire and what your lifestyle will be.
