Should you wait until you have a healthy emergency fund to save for retirement?
You'll often hear that it's important to save for retirement during your working years because Social Security won't pay you enough to keep up with your bills. And there's a lot of truth to that.
Social Security will replace about 40% of your income if you're an average earner. That figure, however, assumes benefits aren't cut in the future, which is a possibility due to the program's financial problems that lawmakers have yet to fix.
Meanwhile, it's debatable as to how much of your former paycheck you'll need to live comfortably during retirement. Some financial experts insist you should plan to need 70% to 80% of your former earnings. Others might say you can get by on less.
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But most likely, 40% of your former income won't cut it if you want to have enough money in retirement to not only pay for essentials, but also, have cash left over to enjoy your newfound free time. For that reason, it's important to save for your senior years during your working years, whether in an employer-sponsored 401(k) plan or an IRA you open and manage yourself.
What if you don't have any money in your savings account for emergencies? Or what if you have a partial emergency fund but still have a ways to go before it's complete? Should you be saving for retirement in that scenario, or diverting all of your extra money to savings?
Focus on your immediate needs first
If you were to lose your job or encounter an unplanned expense your paycheck can't cover, your emergency fund would most likely be the one cash source that could bail you out. That's why having a full emergency fund should trump all other financial goals, including building a retirement nest egg.
Granted, if you have money in an IRA or 401(k) and no emergency fund, you could tap your retirement savings if the need for cash were to arise. But doing so before age 59 ½ triggers a 10% penalty on the amount you remove.
If you encounter a $4,000 emergency expense and you're forced to withdraw that money from your IRA at age 40, when you're not old enough to avoid a penalty, you'll give up $400, just like that. You're actually better off completing your emergency fund and then setting money aside for retirement.
What constitutes a complete emergency fund? It depends on your needs and circumstances.
Generally speaking, you'll want a minimum of three months' worth of essential expenses in savings before moving on to fund your retirement plan. Many financial experts feel that six months' worth of bills is a more appropriate amount for an emergency fund. If you agree, you may want to wait even longer before putting money away for retirement.
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An exception to the rule
If you don't have any money set aside for emergencies, then every extra dollar you have should probably go into your savings account. But if you have some money available for emergencies, just not enough, then you may want to fund a retirement plan before your emergency fund in one situation – when you have a 401(k) and are eligible for a match from your employer.
If you don't put enough money into your 401(k) to snag that company match, you'll end up giving up free cash. As long as you have a decent chunk of emergency savings, you may, in this specific situation, want to put money into your 401(k) despite your emergency fund not being complete.
But otherwise, when it comes to building savings, your emergency fund should take priority over retirement savings. While it's good to start building your nest egg from an early age, you have your whole career to fund your IRA or 401(k), whereas an emergency could strike tomorrow. If you don't have adequate funds in savings, you could face a world of dire consequences.
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