I've heard this for awhile, and I never really understood it but perhaps it's just my particular situation. I can take an interest-free loan from my 401k-type plan at any time. I figure if I lose a job or have an emergency taking $5,000 out of that would be basically the same thing as taking $5,000 out of a bank, except it's been earning returns before that emergency. Do most 401k plans not allow you to take out money from your plan as long as you pay it back?
I think the logic here is that you don’t want to rob your future self to cover your current self’s emergency. Imagine a prolonged expensive period (car breaks, then you get sick, then you need funds to help a desperate relative, etc.) - you need extra money over a period of months but you don’t have it coming in current cash flows. When you borrow from the 401k you have to pay it back, which you won’t be able to do right away, and once you can, your disposable income goes down (because you’ve got to make those payback payments now). While you are paying back you are missing investment growth. I think of liquid emergency funds (in both personal, and business contexts) as insurance - how much you need is defined by your risk tolerance, asset mix, and long term goals, but the answer almost never “none”.
Another thing to think about is increasing monthly disposable income with emergency deferment of payments - in this context stopping 401k contributions while you deal with an emergency. Depending on your debt type, debt load, and credit history you can often negotiate deferment on many monthly payments for months at a time (e.g. mortgage, student loans, some car payments, utility bills, etc.).
This all sounds like the solid advice I've heard before, but your very first line is where my disconnect lies. How is it not robbing my future self to divert that money into a savings account instead of having it sit in the 401k? All the money I would've had sitting in the savings account is likely experiencing growth (over time) in the 401k, making the chunk of cash that would've been sitting in the bank larger through growth. I have a decent percentage of the 401k in bonds, just in case the economy were to tank I'd still have some 401k to draw on (like a savings account).
I do see the issue with having to immediately start making payments back toward the 401k loan, but then I think you just take out a little bit more than what you would otherwise to cover those payments for the duration of the emergency.
Sorry if I sound combative, I am genuinely curious to the responses to these arguments. I'd be happy to find the flaw in my outline if it will help me make better decisions, I just don't see it yet.
401k money = pre tax and is invested. 20k in a 401k = 15k after taxes (random example), and how long will it take you to get that money?
Have you been in a real emergency, where you need serious money within minutes, not days? Because that's what an emergency fund is for. If I need 10k for an emergency right now, I have that available via card within seconds or (entirely) in cash as soon as I can get to an ATM or bank. Not to mention I know exactly how much I have available.
To answer your question, these are the points you're missing:
- Money in a 401k is pre-tax. Any money you want to withdraw will cost you taxes.
- You can't put money back in a 401k after withdrawing it. You will lose the tax advantages on that money forever.
- Withdrawing from your 401k before retirement costs you a penalty on top of taxes:
> If you withdraw money from your 401(k) before you're 59½, the IRS usually assesses a 10% penalty when you file your tax return. That could mean giving the government $1,000 or 10% of that $10,000 withdrawal in addition to paying ordinary income tax on that money. https://www.nerdwallet.com/article/investing/early-withdrawa....
- If you take a loan against your 401k, that comes with a lot of conditions and what-ifs. That's not going to help you in a real emergency.
- Using your 401k to get emergency cash is not going to be quick. If your house burns down in 20 minutes from you reading this comment, it would be nice to have money available to make arrangements immediately, rather than waiting until your 401k loan/withdrawal is ready.
The ideal is to max out your 401k and have an emergency fund _on top_ of that. Using your 401k to fund an emergency will come at significant short- and long-term cost. Having a post-tax emergency fund (again, that's _on top_ of the 401k) gives you short-term security without compromising your long-term security.
Post tax Roth-401k's are a thing. When you quit your job and roll it over to your personal account they also go into your Roth ira. But your point still stands.
You don’t sound combative at all. As others pointed out - the main issues with the 401k is liquidity and taxes. If your going to rely on that as emergency funds you’d want to make sure you had an open line of credit with a sufficient credit limit to dip into while you’re in the emergency room, mechanics shop, etc. You’d want to make sure that you had enough lead time on the payment of that debt to get to the 401k funds, and understand the tax implications.
A final thought here - there’s a temptation to see “emergency” savings as something you _might_ use, but I think for most folks (especially those with families) emergency funds are something they WILL use at some point (life happens, and it’s expensive) - so they need to be saving in addition to retirement planning. If your retirement plan explicitly includes the notion of looting the 401k at some point, then that might work for you - but for most people viewing a retirement account as emergency savings is dangerous because it leaves them under saving for inevitable bumps in the road.
I think the best reason would be to consider what would happen in an emergency situation that goes beyond just yourself - war, natural disaster, etc. What would happen if you needed to flee with very short notice? What if an emergency caused enough chaos that you couldn't take a loan from your 401k, possibly because the electrical grid is down?
Are these scenarios likely? No. Are they a possibility? Yes.
There is some inherent risk in earning that return on your emergency fund. Maybe it's not much but it's there and it's something to be aware of.
401k loans must be repaid when you lose the job. Borrowing against it while unemployed is not borrowing, it's withdrawing. Which means penalties and taxes become due (taxes dependent on if it's a Traditional or Roth 401k).
Now, you may not mind that, but it's worth keeping in mind. So while you're employed, this can work, but once you become unemployed you lose 10% on that withdrawal if you're too young, and maybe also owe taxes. That's a steep penalty.
