Using Your 401(k) and Roth IRA as Emergency Funds

savebuttonbankWe’ve all heard that you should keep an emergency fund in case of unexpected expenses or unemployment. But what if you don’t have the cash? Personal finance author Jonathan Clements presents a mathematical argument for using your 401(k) as an emergency fund in his recent article The Terrible Twenties. Here’s how the math works.

Let’s say you are in the 15% federal income tax bracket and you put $2,000 in your employer’s 401(k) plan. Your out-of-pocket cost would be $1,700, thanks to the initial tax savings. At the same time, your employer matches your contributions at 50 cents on the dollar, with the matching contribution vested immediately. Result: Your $2,000 investment gets you a $1,000 match, bringing your account balance to $3,000.

If you are then laid off and forced to liquidate your retirement account to pay living expenses, you might lose 15% to federal income taxes, plus another 10% to the tax penalty for making a retirement account withdrawal before age 59½. That combined 25% hit would still leave you with $2,250, well above your $1,700 out-of-pocket cost.

To be fair, this isn’t nearly as radical as it seems. Most prioritized lists of “where I should put $XXX?” will put a 401(k) up to the company match as the #1 priority, even above a cash emergency fund.. A company match gives you a way to earn a 50% or 100% instant, risk-free return on your money. This is a rare opportunity that you shouldn’t pass up.

However, not mentioned is that after you exhaust any 401(k) match, you could also consider contributing to a Roth IRA and using that as your emergency fund. The primary reason for this is that Roth IRA contributions can be taken out at any time, without penalty. Unlike Traditional IRAs, withdrawals from Roth IRAs are subject to ordering rules (see Chapter 2 of IRS Pub 590-B), which state that you always withdraw your own contributions first.

In either case, since you can only contribute a certain amount to 401(k) and/or IRAs every year, it would be wise to take advantage of this tax-sheltered space as much as possible. Don’t make a withdrawal if you can avoid it, but if you have limited options, it can make sense to contribute first and hope you can keep the money invested for retirement.

Comments

  1. I max out my contributions per year to my employer 401k plan ($18,000).

    Can I also contribute to a Roth IRA at the same time?

    I am under the assumption that I can only contribute a max of $18k a year into my retirement account(s)??

    • Yes, you may be able to max out your employer 401k AND also contribute to a Roth IRA. You will have to satisfy the Roth IRA income restrictions based on modified adjusted gross income (google search for 2016 limits).

  2. That is terrible advice! if you use your 401k as an emergency fund how exactly is someone going to pay for retirement? Using a Roth IRA is a much better idea since there are no penalties attached. I would say fund your 401k TO the company match, max out a Roth, cash savings to 3 or 6 months salary, and then additional 401k up to the limit.

    • I agree with your priority list. How is it different than what I said above?

      • I was saying the article gave terrible advice by telling people to use a 401k as an emergency savings tool. With all of the penalties and with the loss of compunding growth over he years, a person is missing out on alot by pulling money out of retirement.

        • This advice is meant for folks in difficult situations like the “terrible 20s” where they can’t afford to put money towards BOTH an emergency fund and a retirement account contribution. What would you counsel people to do in such a scenario? Put their limited funds in cash and give up the 401k match?

        • Right, but by pulling your money out of the 401k you are no worse off than having never funded it at all, right? And if you got the match, you are better off.

          • YMMV by circumstance of the emergency, but generally you’re better off funding the 401(k) if you can’t afford to both fund an ER fund and 401(k) for two reasons: first, you miss the match. The match (typically 50 to 100% of contributions) is worth more than the plenty (10% plus marginal rate). Second, if your emergency is job loss (the biggest emergency), your marginal rate drops–potentially even down to 0% (maybe even enough for EITC and other anti-poverty related credits/deductions). Your new, lower marginal plus 10% plenty could be a lower rate than the marginal rate while working. Jonathan is giving solid advice here.

    • Daniel Matsinger says:

      I think the point of this is more for the people who can’t afford to put money in an emergency fund and have to choose between the two. From the example of 15% tax bracket this individual wouldn’t be making too much. So yes, if you need to choose between the two, someones 401k and IRA would be a suitable emergency fund because it has more benefits than just keeping the money in cash. On top of it an emergency fund is just that, a collection of money that is to only be used when theres absolutely no alternatives and immediately, not to waste on wants, so its not overly crazy.

  3. Worth mentioning for any 20 somethings that may be reading that the myRA is basically the perfect vehicle for a Roth/Emergency Fund combo, and although it is capped at $15,000 at that point in your life you should be able to roll it over to a Roth IRA at a brokerage to invest and have an emergency fund set up on the side (thus, Roth/Emergency Fund is no longer needed).

  4. But the money you withdraw will never be replenished. If you take $10,000 from the Roth IRA for an emergency, you won’t be able to put that same $10,000 back in since you are limited to $5,500/year. I suppose this would only really be an issue for people already maxing out their contribution.

    • This advice is meant for folks in situations like the “terrible 20s” where they can’t afford to put money towards both an emergency fund and a retirement account contribution.

  5. Definitely agree it doesn’t have to be cash. I never understood why simple stocks aren’t considered. Sure, you could lose 10,20,30% or so in a year. As long as you can afford an extra 30-40 percent emergency stash this shouldn’t deter you. And since the expected value is positive, there’s really no disincentive to setting aside that extra 30-40 percent

  6. Ah, the terrible twenties. Actually, except for not having a lot of money, the twenties were just fine. If you can max out our 401k and still have money left over for an emergency fund, your twenties are not very bad. In fact, the need for “emergency” money is remote assuming you have medical insurance, willing to drive an older car and curtail your dining. Also, late twenties are a lot different than early twenties.

  7. Italiangirl says:

    And curtail your dating!

  8. Be aware that some states don’t follow the same ordering rules as the Federal government for Roth IRA non-qualified distributions (NJ and possibly others). This makes the Roth IRA as emergency fund calculation a bit different. On the other hand, if the Roth IRA is invested in safe things like CD’s or high yield savings (like emergency funds should be), it won’t make a big difference.

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