Emergency Savings Are Critical To Limiting 401(k) Early Withdrawals From Retirement Accounts

Having an emergency fund is a rule of thumb for financial planning, but a new study found it may have the added benefit of safeguarding your 401(k).

Those enrolled in a Vanguard-administered 401(k) plan that also have at least $2,000 saved in an emergency fund, for example, not only contribute more to their retirement accounts, they also take fewer withdrawals while working and are less likely to cash their retirement accounts out after leaving their jobs.

“If you don’t have a fund set aside for unexpected expenses, you’re going to tap into what you do have,” said Meagan Dow, senior strategist at Edward Jones. “If all that is there is a retirement fund, then you’re going to pull from that.”

Emergency Savings Aren’t Just For Large Expenses

Emergency funds are meant to be there for “in case” scenarios, and even though we don’t like to think that we will need to use them, Dow said they are more necessary than many may think.

“When we say ‘emergency,’ we really are talking about more broadly unexpected, necessary expenses,” Dow said. “My car broke down, I need tires earlier than I expected, a storm came through and damaged my house and I have to come up with a deductible for my insurance policy.”

These expenses may not be thousands of dollars, but they can still throw our savings off track, especially if we don’t have a place to pull from except our retirement accounts when they inevitably pop up.

Pulling from retirement accounts early can incur penalties, including a 10% fee on your withdrawal and having to pay taxes on the amount taken out. Even still, many people do it when they have unexpected expenses because they have nowhere else to turn.

A report from the Transamerica Center for Retirement Studies released in June showed that nearly 40% of people dip into their 401(k) or other retirement savings accounts early. Workers’ top reasons for making hardship withdrawals were covering medical expenses; helping pay tuition and related educational fees; recouping losses incurred in a federally declared disaster area; and making payments to prevent eviction.

While savers can take loans from their 401(k) account instead of withdrawing, the amount of money you can get and when is limited. This is why many make early withdrawals instead, Dow said.

Any Emergency Fund Is Better Than None

Emergency savings make withdrawals less common or necessary. But creating an emergency savings fund can feel daunting, especially when doing it from scratch, and some financial institutions also recommend a savings figure that might not feel attainable.

“Our recommended guidance is three to six months of total expenses, but that’s a huge number for most people,” Dow said. “It’s really easy to get to the point of thinking, ‘Well, I’m never going to get there. Why would I even start?’” 

Because of that, Dow recommends meeting yourself where you are, even if it’s only $5 a paycheck or cutting one subscription service a month. If you can do more, though, that’s even better.

“Try to create the habit of living below your means, so that you do have flexibility when something comes up,” Dow said.“The lived experience of ‘This popped up, and I could handle it’ is a reward that does help motivate us to save going forward. Being able to handle it when you didn’t think you could, or might not have before, is really empowering and freeing.”