It’s a statement practically shouted from the personal finance rooftops: “max out your 401k.” I have to tell you, I cringe every time I hear this advice. In theory, it’s great, and we should all be saving for retirement. But this advice doesn’t work for everyone. There are lots of reasons contributing a lot to your 401k may not work for you, but today I’m going to focus on my #1 reason not to max out your 401k: you need to set up an emergency fund first.
An emergency fund is your safety net in case the unexpected happens – you lose your job, need car repairs, have a medical emergency, etc. The last thing you want in a stressful situation is to debate between going into serious debt and paying your rent. How much should you stash away in the fund? Guidelines say about 3 to 6 months of living expenses.
Here’s a scary thought though: more than a quarter of Americans have no emergency savings, and only 40% have at least three months worth of expenses saved!
In my opinion, your emergency fund should be your #1 savings priority, particularly if you are far from retirement or have a family. The peace of mind and flexibility it gives you are invaluable. And the fund doesn’t have to just be for bad things. Suddenly realized you need to change careers to follow your passion? Not so terrifying when you have a money backup plan.
The catch is though, you can’t just keep your emergency fund anywhere. Your emergency fund needs to have two key features:
You can withdraw from it at any time, with no penalties
This is the issue with maxing out your 401k in lieu of setting up an emergency fund; a 401k doesn’t work for short-term emergencies.
A 401k comes with tax benefits, but also with a catch. If you withdraw money from your 401k before you are 59 and a half (I know, random), you have to pay taxes on the money, plus a 10% penalty. There’s no need to be donating money like that to the government. So unless you are 59 and 1/3, don’t count on using your 401k in a pinch. There are a few hardship exceptions to the fees, but the thresholds are so you can’t count on them (and honestly, you wouldn’t want to qualify).
[Note: If you insist on setting up a retirement fund before an emergency savings fund, a Roth IRA is a better move than a 401k. You can withdraw on the contributions, but not earnings, you make in your Roth IRA without any penalties.]
That also means a CD (essentially a savings account that gives you a higher interest payment in exchange for giving your money to the bank for a few years) may not be a good place to put your emergency fund, as you’ll have to pay early withdrawal fees there too.
It’s not risky or subject to market fluctuations
As much as I love the stock market, it is not a great place for your emergency fund. Unfortunately with the market, you don’t know if investments worth 6 months of expenses today will be worth 12 months or 2 months a year from now. And you don’t want to be forced to sell a stock at a major loss because of timing.
So what’s left? For my emergency fund I use a high yield savings account from Synchrony Bank, which pays me 0.95% annual interest, and is zero risk. I put in a chunk up-front, and set up automatic payments to the account every month so I don’t even need to think about saving.
In theory you could also use a money market fund, which is a mutual fund that only invests in short-term, very low-risk securities like treasury bills and CDs. According to Vanguard, money market funds have had an average annual return of 1.34% for the past 10 years, but closer to 0% for the past 5 years since interest rates have been so low.
If you go the money market fund route, watch out for hidden fees. You want the expense ratio to be as low as possible, and make sure you’re not being charged an annual service fee as well (Vanguard charges $20 a year unless you sign up for paperless billing).
Also of note, a money market fund is not FDIC insured like a high yield savings account through a bank is. That means if the money market fund goes under, your money might not get returned (highly unlikely, but possible).
So the next time someone tells you to max out your retirement accounts, please take a good look at your emergency fund situation first. Better safe than sorry in this case.
p.s. Look out for more 401k and retirement fund posts coming up! I know there are a lot more questions I have to answer on the subject.