401(k) vs The Emergency Fund

Posted on December 10, 2008
Filed Under emergency fund | 7 Comments

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In talking to a friend about building an emergency fund, they commented that they didn’t need an emergency fund because they had a 401(k). Their feeling was that because they could borrow against their retirement fund, it would serve as an emergency fund. We got into quite a discussion about it because I used to think the same thing. My experiences over the last few years have proven otherwise.

The reasons are plentiful and not really complicated. There are two ways to use your 401(k) as an emergency fund, you can withdraw money or you can get a loan. I am going to start with withdrawing money as it is the easiest to understand. The following example is from the Bloomburg Spend or Save calculator and based on a 29 year old with an 8% rate of return who is in the 25% tax bracket.

Taxes and Penalties. If you withdraw money from your 401(k), you are going to pay taxes on the amount your withdraw plus penalties. It may also throw you into a higher tax bracket and cost you more in taxes on the rest of your income. Withdrawing $10,000 from your retirement will cost approxi mately $3,000 in taxes plus another $1,000 in penalties.
Loss of Interest. You have to remember that you are not only losing the money that you withdraw from your retirement, you are also losing all the interest that it would generate. When you retire at 65, your retirement will be $159,682 less. That is $149,682 in interest and the $10,000 you withdrew.

That is a hell of a loss from your retirement and how long will the $6,000 you actually recieved last if you were using it to pay all of your monthly living expenses?

Now let’s look at taking a loan against your 401(k). It seems like a really good idea, you are borrowing your own money, the interest rate is low and repayment terms are easy. This example is taken from BankRate’s 401(k) loan calculator using a 30 year old borrowing $10,000 earning 8% on their retirement, paying 4% interest and repaying the loan in 5 years.

Loss of Interest. If you repay the loan on time, you will have lost $43,741.50 in interest. A pretty hefty amount for a 5 year loan.
Loan comes due, if you change employers or lose your job. This happened to me. I had a loan against my 401(k) and when I switched jobs, it was due and payable within 30 days or it converts to an early withdrawal. In the example above, the lost interest, penalties and taxes cost me $175925.50. OUCH! Do you plan to stay in your current job for long enough to pay off the loan? Is your job recession proof? Right now, companies are cutting back drastically and laying off large amounts of their workforce.
Time to recieve funds. Most 401(k) loans take an about 2 weeks to receive the funds. What do you do in the meantime if you need the money to repair your furnace or your car?

My question to those of you who are using your 401(k) as an emergency fund, are you really willing to spend/lose that much money because you need a new stove or a new transmission in your car? I am not talking about long term unemployment or disability, I am talking about those smaller emergencies that seem so huge when you don’t have liquid cash.

If you choose to use your retirement fund as an emergency fund, my advice is to find a compromise and at least have a smaller liquid emergency fund. Dave Ramsey recommends a minimum of $1000 which will cover small emergencies, repairs and unexpected expenses.

What do you think? Do you depend on your retirement fund for emergencies? Do you have an emergency fund?

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Comments

7 Responses to “401(k) vs The Emergency Fund”

J. Money (2 comments.) on December 10th, 2008 3:57 pm

Well, you put it a lot nicer than i do I had a similar story about this idea, except i overheard it on my way in to work one day….i was going to interject, but held off and decided to post about it instead.

You’re more professional about discussing the options though – good post!
cindys on December 10th, 2008 4:03 pm

LOL. Whatever it takes to get the message across. Everything you wrote is true too and sometimes people don’t get it until you smack them with a two by four. I would be one of them….
Denise (26 comments.) on December 10th, 2008 7:35 pm

Well, I don’t have a retirement fund (I’m a very late bloomer) but do have an emergency fund and its for just that, emergencies. I hope to get a retirement fund of some sort going soon and when I do I’ll remember this entry and J Money’s entry, also. Hopefully, I won’t need to be smacked with a two by four.
Frugal Babe (1 comments.) on December 10th, 2008 8:20 pm

We have an emergency fund that we set up a few years ago, with an automatic contribution of $100/month into an online saving account. The first year we had it we were pretty broke, and kept raiding it to pay the mortgage. But for the last two years we haven’t touched it. My husband had knee surgery this year, and we have a $3000 health insurance deductible, but luckily we had also been funding an HSA for the last couple years, so we didn’t have to use our emergency fund to pay the deductible. I like knowing that the emergency fund money is there (and growing) just in case.
cindys on December 10th, 2008 8:25 pm

Denise, It sounds like you are on the right track and I will put the 2 X 4 down.

Frugal Babe, I was amazed at how much less stress I felt with even my tiny little emergency fund. It is so nice to know that if the unexpected happens, you can cover it.
Bouncing Back Betty on December 11th, 2008 11:12 am

When I was in fiscal meltdown, I tapped in to my 401K to try to “help myself out”. It really did not help matters at that point. Oh well, live and learn. I was in my biggest debt denial stage at that point in time and grasping at anything that might help me out.

I do have a small emergency fund now, about $1300 tucked away in two accounts. I’ve had to dip into the fund at various times during the year (replace a broken storm door, fix a neighbors truck window I broke, help with my recent car repair). I’ve had as much as $1800 in it and as little as $900. But just knowning it is there if I need it is a big relief.
Denise (26 comments.) on December 11th, 2008 12:00 pm

Bouncing Back Betty, I have to agree 100% that just knowing the money is there goes a long way in providing peace of mind. And peace of mind has a value in and of itself, huh…