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WHEN I WAS IN MY 20s, with two young children to provide for, I had neither an emergency fund nor nearly enough life insurance. I knew both were important—but I simply didn’t have the money to spare.
Make no mistake: Launching a financial life is daunting. Most twentysomethings have modest incomes, and yet they’re supposed to save for retirement, buy a car, build up an emergency reserve and put aside money for a house down payment, plus have all the necessary insurance coverage. And the financial stress often doesn’t stop there: Those in their 20s may also be servicing student loans and starting a family. Something has to give.
The prudent approach is to focus on risk—and that means your top priority should be amassing an emergency fund equal to as much as six months of living expenses, so you have a financial backstop in case you lose your job. But this is also the dreariest of financial goals. Who wants to worry about getting laid off?
It’s so much more fun to save for a house down payment and watch your retirement nest egg grow. Moreover, preparing for financial emergencies means stashing a heap of cash in conservative investments, where it will thereafter earn modest returns—and perhaps never be needed.
Meanwhile, you could be socking away money for retirement and reaping handsome financial benefits. For instance, if you fund your employer’s 401(k) plan, you will collect investment gains, enjoy an immediate tax deduction and possibly receive a matching contribution from your employer.
My contention: Funding your employer’s retirement plan should be the top priority—and, if necessary, it can double as your emergency fund. Financial heresy? 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. Moreover, if you are unemployed for a long period, you may have little taxable income in the year you cash in your retirement account, so your income tax bracket could be below 15%. The counterintuitive conclusion: For cash-strapped twentysomethings, funding a 401(k) could be the smartest way to build up an emergency fund.
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Jonathan,
I think you’re a genius because you agree with me. You might also point out that assets in a qualified retirement plan are generally sheltered from attachment except for a qualified domestic relations order or child support. Also, the tax penalties associated with early withdrawals make a wonderful excuse to say “no” to deadbeat relatives and acquaintances who want to “borrow” the money from you.
Dave