We talk a lot about saving for retirement and rightfully so. But many people get started with retirement savings without establishing a baseline of financial security for themselves: an emergency fund. A sound financial practice is to have 3 to 6 month's worth of living expenses in an easily accessible account to help you in case of an emergency. Here are three reasons to set up an emergency fund prior to investing for retirement.
1. You'll be ready when life happens. There are certain situations in life that require a larger amount of cash than the typical monthly budget allows, such as job loss, a major car or home repair, or a large out-of-pocket medical expense. As a way to self-insure for these instances, you need enough cash on hand to get you through the tough time.
2. You won't have to rely on credit. As we've seen during the recent credit crunch and housing crash, credit isn't always going to be available to tap for emergencies. It’s better to have cash on hand. And even if you do have the credit, resorting to credit cards during a crisis could do even more harm. If you can't afford to pay off the balance by the end of the month, then you'll be forced to carry a balance and incur ridiculous interest charges. Plus, you might come close to maxing out your credit card limit, which could negatively affect your credit score. An emergency fund helps you avoid this situation all together.
3. You won't have to dip into retirement accounts. If you have the cash on hand, you won't need to dip into or borrow from the retirement savings you already have. Your retirement accounts are meant for your retirement. Pulling money from these accounts early to fund an emergency has several negative consequences. You'll be forced to realize any gain or loss that you're currently experiencing. If the market is down, you'll be pulling money out of the market at a bad time. When the market rises again, you'll miss those gains because you pulled the money out. If the retirement account was funded with tax-deferred dollars (as traditional 401(k)s and IRAs are), you will be required to pay taxes on that money. This can mean a big cash outlay right at the time you need every penny you can get. And you might even face a 10 percent early withdrawal penalty from the IRS if you can't prove that this withdrawal is for a qualifying hardship. Who wants to pay a penalty when they are scraping up dollars to fund an emergency situation?
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Setting up an emergency fund is easy. Open a simple savings account. I like using an online savings account because they help you keep the funds separate from your other accounts and they even pay you a small percentage of interest on your balance. The typical advice is to have around 3 to 6 month’s worth of expenses in a savings account. If you’re more conservative or work in an unstable field, aim for more than that. Start saving every extra dollar you get into that fund until it’s built up. Then you can switch back to worrying about retirement savings, knowing that your short-term needs will be met.
Phil Taylor is the author of the popular 52 Ways to Make Extra Money. Find out how to save more money and get the latest news on the best online savings accounts and the best online stock brokers at his blog, PT Money: Personal Finance.