THERE ARE CERTAIN hallmarks of financial rectitude: Never carrying a credit card balance. Maxing out the 401(k). Having an emergency fund. But do these habits deserve the sacrosanct status they’ve achieved?
You won’t find me arguing with paying off the credit cards each month or putting at least enough in a 401(k) plan to earn the full matching employer contribution. Both make ample sense. But in the past, I’ve raised questions about how much emergency money people need and how they should handle this money. Every time, I get an earful from readers, alarmed by my financial sacrilege.
I recently stumbled into this controversial territory again, when I suggested that—once retired—folks may not need an emergency fund. Has the man gone completely mad? At the risk of further inciting readers, let me offer three contentions.
1. An emergency fund is really an unemployment fund. If we’re out of work for an extended period, we could easily run through tens of thousands of dollars, which is why the standard advice is to keep emergency money equal to three-to-six months of living expenses. What if we’re retired? Unemployment is no longer a risk, so an emergency fund may be unnecessary.
But what about the other emergencies that people cite—things like replacing the roof, repairing the car, needing nursing home care and paying large medical bills? I’d argue that either these things aren’t true emergencies or the potential financial damage isn’t all that great.
For instance, we know the roof will need replacing at some point, so it isn’t really an emergency expense. Rather, it’s a known upcoming cost and we should simply save the necessary money. Similarly, we ought to have a plan for nursing home costs before we quit the workforce. That plan might involve paying out of pocket, perhaps with help from long-term-care insurance. Alternatively, we might accept that we’ll deplete our assets and then fall back on Medicaid.
What about a car repair? It ought to cost less than $1,000 and, if it’s more, it probably means we had an accident, at which point insurance should kick in. Ditto for medical bills. They should be largely covered by insurance. Indeed, as we ponder how much cash we need easy access to, we should give some thought to deductibles, elimination periods and maximum out-of-pocket expenses on our various insurance policies. For instance, under the Affordable Care Act, the 2018 maximum out-of-pocket expenses on a health insurance policy are $7,350 for an individual and $14,700 for a family.
2. Emergency money is typically dead money. It sits in a money-market fund or savings account, earning an after-tax interest rate that is typically below the inflation rate. This is not a desirable situation—which means we should carry as little emergency money as we can get away with.
To that end, we should focus not on how much cash we ought to hold, but on how much we need access to. For instance, if we have a $100,000 home equity line of credit, we may be comfortable holding far less emergency money.
Because emergency money typically earns such a low rate of return, I also question conventional wisdom, which argues that building up a large emergency fund should be the top priority for young adults entering the workforce. At that juncture, we typically have modest salaries, but a wonderfully long time horizon. Wouldn’t it be better to focus instead on funding retirement accounts, thereby getting long-term compounding working to our advantage?
If young adults later find themselves unemployed, they could always pull their original contributions out of their Roth IRA, with no taxes or penalties owed. They could even cash in their 401(k). Sure, that would trigger taxes and penalties. But if the 401(k) had paid an employer match, often folks will still come out ahead financially.
3. A separate emergency fund may be unnecessary. As our wealth grows, we’ll likely accumulate other savings in our taxable account. Let’s say our taxable account holds $100,000 that we’ve earmarked for retirement.
Do we really need a separate $20,000 for emergencies? If we lost our job, why wouldn’t we just dip into the taxable account jar we’ve mentally labeled “retirement”?
True, that retirement money might be invested entirely in stocks and, when we need to sell, those stocks might be in the midst of a bear market. But even as we sell stocks at depressed prices in our taxable account, we could shift an equal sum from bonds to stocks within our retirement account. Result: We would maintain our portfolio’s stock exposure—and effectively sell bonds to pay for our emergency.
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This is true for federal taxes but not for every state. For example, the state in which I live, New Jersey, applies a penalty on early withdrawals—even of original contributions. I wish I had known that before I used my Roth IRA as a place to stash emergency funds. No one seems to mention that rules can vary by state in this kind of article.
Thanks, Kathryn. I had never heard of states levying penalties on withdrawals of Roth contributions. What’s the penalty in NJ?