Thursday, November 4, 2010

Emergency Fund Example

Here's a comment that I got in response to a recent article on Emergency Funds:
So, given the reality that the average associate is using all 'extra' money to pay student loans and probably isn't saving much more than max 401(k)/IRA contributions (if that), do you advocate having a separate non-retirement brokerage account for emergency fund purposes, or is it good enough to have the ability to borrow from the 401(k)/withdraw from the IRA if needed? This isn't hypothetical; I'm a second year associate with about $50,000 in retirement savings, a few hundred in a traditional brokerage account, and never more than $2,000 in the bank. A HELOC isn't an option, as I live in NYC and rent.
That's a great comment and it raises several points to consider.  Let's take a look at them below.

First, let's think about the limitations of a 401(k) account or an IRA account vs. a traditional brokerage account.  With a 401(k) account you can typically get a loan for up to 50% of the account balance, but not more than $50K.  The setup fee is minimal, the interest rate is typically pretty low, and the interest paid goes to you.  Let me repeat that - the interest that you pay on the 401K loan goes into your 401K account.  You are paying yourself for the use of your money - so you are really not losing interest to anyone else.

That all sounds good.  However, if you are terminated or quit you must immediately repay any outstanding loans to the 401K account or else they are treated as an early withdrawal - which means that they are taxed at ordinary income rates plus a 10% penalty is attached.  Ouch.

One other aspect is that the 401(k) loan typically takes about 2-3 weeks to come through, so it is really not immediate access to your money.  Also, you can only have one outstanding loan at a time, so your emergency fund would be a one-shot deal.

Bottom line - if you can afford to wait 2-3 weeks to get access to the money and are certain not to get fired before you finish paying back the loan, then using the 401K loan as an emergency fund is not terrible.  However, that would only be the case if you are using it as an emergency fund for risks like "car trouble" or similar - in which case you may very well be better off just putting it on a credit card and paying it off as fast as you can.  Certainly, the 401K loan is not going to be a useful emergency fund to you if you get fired - you will no longer be able to take loans and every distribution with be taxed and have a penalty.

With regard to the IRA, technically, there are no IRA loans (but you can do a rollover and have 60 days to put the money in the new account.)  If we withdraw money from an IRA, we immediately get taxed as ordinary income with a penalty attached.  Consequently, the IRA does not make a good emergency fund in any situation.  Leave it alone and put it on your credit card.

You mention a brokerage account as your third option - and a brokerage account is good because most of them can give you access to your money in 3 days - if not sooner.  Also, it's usually after-tax money, so no taxation or penalties.

I think that you can probably see that one important question is - what are you going to call on your emergency fund to do?  What are the particular risks that you view the emergency fund as providing insurance against.  How big of numbers do you need to come up with - and how fast?

If the number is less than $10K (which it typically would be in all but the "getting fired" situation) and you have the ability to free up $2,000/month or so (for example by reducing your loan payments, temporarily stopping 401K contributions, changing your withholding, changing your personal spending, etc), then you might as well just get a credit card with a high limit and low interest rate as a "just in case" emergency fund.  It's going to be a lot easier than getting a loan from the 401K.  You won't have to worry about whether your investments will be up or down if the emergency happens.

However, if the risk that you are using the emergency fund to compensate for could not be paid off in 4-6 months, then the interest that you would pay on a credit card would be significant and maybe you would be better off having more ready cash in a brokerage account.

Here's a strategy that you may not have considered - there's nothing that says that you can't get several credit cards and just keep them alive with no balances as a ready credit line in case you need it.  Get credit cards without a yearly fee so that there would be no cost to you to keep these lines open.  Additionally, you would most likely want to get rid of many of them if you were ever in a position to buy a house because that much open credit may negatively impact your credit report.

Turning now to the "job loss" risk"  - one thing that is nice about retirement accounts like a 401K and IRA is that they are typically not attachable in bankruptcy.  Conversely, credit cards typically are dischargable.  Also, cash in a brokerage account would typically be attachable in bankruptcy.  Most bankruptcies now would try to push you into a repayment plan for several years before immediately clearing your debts, but by using the credit cards as the emergency account and putting the money into the 401K instead of the brokerage account, you could end up maximizing the positive financial aspects of a bankruptcy by having the credit card debt wiped out and your retirement accounts untouched (the brokerage account, on the other hand, would be liquidated to pay your credit card debt).

My suggestion is to continue maxing on the 401K and IRA and just get credit cards in place in case of the less-than-10K emergency.  You may also wish to manage your loan repayment to start putting money toward the brokerage account, depending on loan interest rate.  For example, if the loan is at more than 8%, pay the loan- but if the loan is at less than 8%, then maybe we start thinking about a 90-10 split between loan payment and brokerage.  If the loan is at less than 5%, then maybe a 50-50 split, etc.

For the more-than-10K emergency, (most likely loss-of-job) there's not much you can do.  If you find another job quickly, then you are probably inside the less-than-10K window.  If not, then having some room on the credit cards might allow you to push having to access your retirement accounts into the next year - which could lower your tax rate on them considerably.

For example, let's say that you get fired today and won't find a job until 2012.  At your current salary, you are probably already in the 28% or 30% brackets.  Consequently, any 401K or IRA withdrawal will be hit with a 28 or 33 % tax plus a 10% penalty (total 38 or 43% lost) if you withdraw this year.  However, by waiting until next year when you have no income, the total lost would be much lower - 10% up to $8.3K and then 15% up to $34K - even with penalty, that's only a total of 20%-25%

As always, I wish you the best of luck!  May you never have to call on your emergency fund!

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