This past year has been a doozy, and the humble emergency fund is enjoying a moment in the spotlight. As the coronavirus pandemic rages on, it's never been more critical to have a solid stash of savings.
But even if your job is secure and you don't foresee any major expenses, it's still wise to have some cash socked away in an emergency fund. Not only will it help you be more prepared in case of an unplanned cost, but there are also a few ways it can help you save more for retirement too.
1. It can help you avoid hefty penalties
Nearly one-third (30%) of Americans withdrew a portion of their retirement savings to cover unexpected expenses due to the COVID-19 pandemic, according to a 2020 survey from MagnifyMoney.
While it can be tempting to tap into your retirement savings when you need some extra cash, you may face penalties for withdrawing your money before retirement age. If you're investing in a 401(k) or traditional IRA, you'll typically incur a 10% penalty fee and income taxes on any savings you withdraw before age 59 1/2. Even one early withdrawal can amount to hundreds or thousands of dollars in penalties, and repeated withdrawals will add up to even more.
When you have an emergency fund, it's easier to avoid raiding your retirement fund. As a result, you can also avoid wasting money on penalties.
2. It can help you avoid the risks of 401(k) loans
Some 401(k) plans allow you to borrow money rather than withdrawing it, which can help you avoid the 10% penalty and income taxes. However, there are a couple of significant risks involved with these loans as well.
For one, your 401(k) loan is tied to your employer. If you leave your job for any reason while you have an outstanding loan (whether you leave voluntarily or are laid off), you generally need to repay the full amount of the loan immediately or risk defaulting on it. This is especially worrisome during a pandemic, when job security is a major concern for millions of Americans.
In addition, repaying the loan can be difficult when money is tight. If you're struggling just to make ends meet, adding a loan payment to your list of bills to pay can be overwhelming. With an emergency fund, though, you can avoid 401(k) loans -- and their risks -- altogether.
3. It will allow your savings to grow uninterrupted
Your savings grow with help from compound interest. And compound interest is most effective when it's allowed to work uninterrupted. Every time you take money out of your retirement fund -- even if you pay it back later -- you're disrupting your money's growth.
Compound interest is like a snowball rolling down a hill. If you leave the snowball alone and let it roll undisturbed, it will become larger and larger over time as it picks up speed. But the more you interrupt the snowball, stopping it or moving it further back up the hill, the harder it will be for it to grow.
Taking one relatively small withdrawal from your retirement fund likely won't have a drastic effect on your long-term savings. But chances are you'll experience many unexpected expenses between now and retirement, and if you tap your retirement savings each time, you could be significantly limiting your money's growth potential.
Building an emergency fund can be tedious, but it's one of the best ways to protect your finances. By socking away enough cash to cover at least three to six months' worth of living expenses, you can avoid dipping into your retirement fund and save more for your senior years.