Emergency: Break piggy bank, not nest egg
A hefty retirement fund is great, but it's good to have an emergency stash of cash, too.
NEW YORK (Money) -- Question: I'm 25 years old and am considering upping my contribution to my 401(k) from 20% of my salary to 30%. My only hesitation is that I don't currently have any other savings. What do you think? Should I just go ahead and build my 401(k) as much as I can or should I set aside some savings in another account? --Jonathan M., Rockville, Maryland
Answer: It's not often that I find myself in the position of telling people who want to contribute more money to their 401(k) that that they probably shouldn't. I'm usually doing the opposite: encouraging people to sock away as much as they possibly can in their workplace plans.
In your case, though, I think that, for now at least, you'd be better off using the extra 10% of salary to build an emergency savings fund equal to three to six months' worth of living expenses.
The reason is simple. Life, like the financial markets, can get bumpy, and it's nice to have a reserve fund that you can fall back on during turbulent times. Without such an emergency stash, you might have difficulty meeting an unanticipated expense or coping with a financial setback such as the loss of a job. Even if you could tap your 401(k) for emergency cash, it could be a hassle or expensive or both.
With a loan, for example, you'll have to repay it with interest. If you can't make the payments and the loan goes into default, you would owe taxes and a 10% early withdrawal penalty on the amount of the loan and, possibly, accrued interest. (Here's more on the potential pitfalls of a 401(k) loan.)
As for a hardship withdrawal, even if you meet the stringent requirements, you don't get a pass from the taxman. You'll still owe tax and a 10% penalty.
Suffice it to say, you'll have a lot more maneuvering room and be better prepared to get through a rough patch financially if you've got savings aside from any money you have in 401(k) and IRA accounts.
And fortunately, it's not like you'll be jeopardizing your future retirement security by not increasing your 401(k) contributions. Why? Well, if you go to our How Much You Need to Save Calculator and plug in your age, annual income, and the amount you already have saved, I think you'll find that someone your age putting away 20% of salary is probably already saving more than enough for a comfortable retirement. That's not to say that you should slack off. A lot can happen over the next 40 or so years, so it's always good to have a nice cushion. But given your tender age and your prodigious savings rate, you certainly don't need to worry about delaying going to a higher contribution rate until after you've created your emergency savings fund.
Assuming you do build an emergency stash as I suggest, I think you ought to keep this money in highly secure and liquid investments -- short-term CDs, a bank savings or money-market account, or a high-quality money-market fund -- in a regular taxable account. That way you'll have unfettered access to your stash.
But if you're really bummed out about missing the opportunity to save more bucks in a tax-advantaged retirement account, I'll throw out one idea that could allow you to have ready reserves for an emergency but also reap some tax benefits at the same time: open a Roth IRA account (assuming you qualify, of course).
I mention this, because the Roth IRA has a feature that can allow it to double as an emergency savings stash --namely, you can withdraw your own contributions at any time without paying tax or penalty on them.
So, for example, if you contribute $5,000 to a Roth IRA this year (which is the max in 2009 for people under 50) and $5,000 next year, you would have $10,000 that you could withdraw in a pinch without paying tax or penalties.
This approach has a downside, though. If you really want to be sure your Roth contributions will be there for you to meet a cash crunch, you'll have to invest them the same way you would the money you put in a taxable emergency fund -- i.e., money funds and the like. Which means a young person like you who should be investing his retirement savings predominantly for growth might have a sizeable portion of his nest egg in low-yielding cash equivalents.
What's more, you wouldn't have access to anything in your Roth IRA beyond your own contributions unless you pay tax and, unless you qualify for one of the limited exceptions, a 10% penalty.
Given these drawbacks, I think you're probably better off just building your cash reserve in a regular old taxable account. It's simpler and cleaner. Once you've done that, you can get back to fattening your retirement accounts even more by increasing your 401(k) contributions. Or you might even try a strategy I've mentioned before of complementing your 401(k) with a Roth IRA (although in this case, the Roth would serve as a retirement account, not as a cash cushion).
So as much as I admire your zeal to save even more for retirement, I suggest you channel those extra resources toward an emergency savings fund. By doing that, you'll have more financial security during your career, and you'll reduce the chances of a layoff or other financial setback derailing your retirement plans.