Retirement plan decisions made easy
Drill Down: Contribute to a 401k or Build Up a Savings Account?
Financial planning experts have long advised families to have an emergency fund, often suggesting it total six months of income. Although that is a high hurdle for most families, the logic of a rainy day fund is strong.
Let’s consider your risks. If you car’s transmission blew up tomorrow, would you be able to get to work? If your son broke his arm while trying to climb a tree, would you be able to pay the deductibles and co-pays required by your medical insurance? If you suddenly lost your job, would your family have food on the table and a roof over its head until you found work?
If the answer is “no” to any of these questions, you have a problem. But the answer may not be “no” even if you don’t have much savings. First, let’s look at the degree of risk you face. If your car is still under warranty, you have less risk than if you’re driving a well-used car. You have less risk if your health plan requires only minimal cash payments or if you work for a healthy company in a stable industry.
Even with significant risk, there are alternatives to six months of income in the bank. Your credit cards offer a last line of defense against temporary emergencies. Notice the key point of that sentence: The credit card should be a last line of defense, not a routine way of funding vacations and retail therapy. Let’s say that you follow my recommended practice for credit cards and pay the balance off in full every month. Then you have a good bit of credit available when your car gets sick. If your credit limit is low, ask for an increase; you can often get a higher credit limit just for asking if you have a good credit history.
If you own your own home, and you have some equity, consider a home equity line of credit. Your bank agrees to lend you money in the future, but you don’t have to take the money out now; you just wait until you need it. You may be able to get a line of credit without paying any fees in advance, which is great if you are planning on using it as a safety net. Just be sure that you have the discipline not to tap into your credit line for luxuries.
But suppose that you don’t have much available credit on your plastic or home equity, and you have normal risk of financial difficulties. Then you need to get a savings account.
In most 401k plans, you can borrow money from your own 401k. That provides another layer of protection from the devilish transmission or the unexpected medical expense, but it does not help at all in the event that you lose your job. In fact, you may have to repay any loans to your 401k immediately if you lose your job. If you can’t pay off the loans, the money you borrowed is considered a distribution. You owe tax on it, as well as a ten percent early distribution penalty if you are under age 59 1/2. All of this would happen at a time when you are least able to pay extra taxes. (See the chapter on loans for more details.)
The bottom line on loans from your 401k is that they add a layer of protection. If your job is very secure, then the layer of protection is thick. If your job is at risk, then it’s a thin layer. Don’t count on it. And while hardship withdrawals could also be an option, they have tax consequences and are limited in use. (See the chapter on that subject for details.)
The worst part about the idea of building up a savings account first is that you can’t just ignore the 401k in the hopes that someday you’ll build up a savings account. You need to make a definite plan to build up that savings account. Allocate all available cash for the next six months to the savings account. Decide on a fixed amount you’ll add to savings out of every paycheck. Put the money into a separate account, not your routine checking account. Cut expenses to the bone. Every payday, put money into the savings account before spending it on other things.
You are not logged in. Log in or create an account.
Click here to sign up for our monthly newsletter delivered via email.
Lesson 1: What the Heck is a 401k, and What’s So Great About It?
» Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
The 401k ebook is available in text, audio, and video formats. The current selected format is text. You may also switch to the audio or video formats by clicking on the icons at the top of the main lesson page.