Life can be unpredictable. Even if you're great at following a budget, you may have periods when your bills come in higher than expected.
If your roof springs a leak, for example, that's not the sort of thing you can plan for. Neither is a broken leg and hefty hospital bill to follow.
Image source: Getty Images.
That's why it's so important to have an emergency fund at all times. That money can cover not only unplanned bills, but a period of unemployment.
If you don't have a dedicated emergency fund but you do have a nice pile of money sitting in an IRA or 401(k) plan, you may be inclined to use your retirement nest egg as your backup plan. But here's why having a separate emergency fund is a much better bet.
Raiding retirement savings early has consequences
If you're sitting on a pretty nice sum of money in your IRA or 401(k), then you may inclined to skip the emergency fund. After all, if you have $240,000 socked away for retirement and need $2,400 in pinch to cover a car repair, that's just 1% of your nest egg. Surely you can replenish that money over time, right?
Well, it's not that simple.
First, you should know that when you raid an IRA or 401(k) before turning 59 1/2, you're generally subject to a 10% early withdrawal penalty. That $2,400 car repair withdrawal? It'll cost you $240 off the bat.
Secondly, when you take a withdrawal from a traditional IRA or 401(k) plan, that distribution is taxable. This holds true whether you're tapping your savings early or not. So whatever amount you need in a pinch, you'll need to withdraw more than that to cover the associated IRS bill.
Furthermore, when you raid your IRA or 401(k) early, the money you withdraw is no longer invested. That could cost you in the long run.
Say you withdraw $2,400 at age 35 to fix your car but don't retire until 65. If your portfolio gives you an 8% yearly return, which is a bit below the stock market's average, you could end up losing out on over $24,000 due to forgone earnings. That's a much bigger deal than retiring with just $2,400 less.
Figuring out an ideal emergency fund
If you're already in the habit of funding a retirement account, then building an emergency fund may be pretty easy for you. But how big should that emergency fund be?
The general convention is to save enough money to cover three to six months of essential bills. That should, in theory, get you through a period of unemployment and also suffice for large bills like home or car repairs.
However, if you're in a niche industry or have a very specific role, you may want to save up a nine- to 12-month emergency fund, just in case. In fact, having up to a year's worth of expenses isn't a bad idea if you work in an industry where jobs aren't abundant these days.
While you might think you're equipped to deal with emergency expenses if you have a decent nest egg, remember that your IRA or 401(k) is supposed to be reserved for retirement only. Raiding your long-term savings early puts you at risk of penalties and an eventual shortfall. You're better off building a dedicated emergency fund so you don't have to jeopardize your financial future.
