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When Your Emergency Fund Isn't Enough

Tue, 8 Dec 2015

Vanguard's Colleen Jaconetti explains why financially pinched investors should only tap into their retirement plans as a last resort--and what to do instead.


Video Transcript

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Prematurely raiding your retirement assets is rarely a good idea. I recently sat down with Vanguard's Colleen Jaconetti to discuss the least-bad options for investors who are in a financial pinch.

Colleen, thank you so much for being here.

Colleen Jaconetti: Thank you for having me.

Benz: You wrote a piece about raiding your retirement portfolio. This is kind of a pitfall that investors fall into, sometimes out of necessity, where they need some emergency funds. But let's start with the baseline idea. Why is raiding your retirement plan--even though your balance might look nice and plump after several years of good returns--why is that generally not a great idea?

Jaconetti: Well, it's really not a good idea because you're using the monies today, and what could happen is you'll end up being in retirement and falling short of being able to meet your spending needs there. So, a lot of retirement accounts are really built with tax-deferred or tax-free growth in mind. If you combine those two features with compounding, it really goes a long way to help people have enough money to meet their spending needs in retirement. So, taking that out--removing the tax-advantaged growth and the compounding on that--means investors would really have to contribute a lot more toward their retirement later on. So, if you can leave your money in the retirement account growing tax-deferred or tax-free along with the power of compounding, you can actually contribute a lot less toward retirement over time.

Benz: And in many cases, by the time you factor in the tax haircut and perhaps the penalty on that withdrawal from a traditional tax-deferred account, you really see the amount that you are able to take out shrivel quite a bit.

Jaconetti: Absolutely. If someone takes money out of the pretax dollars they put into their 401(k) or traditional IRA, they would actually have to pay ordinary income tax on the withdrawal as well as a 10% penalty if they are under 59 1/2. So, a $10,000 withdrawal could quickly become $6,000 or $7,000. So, it really is more beneficial to leave those monies growing, if possible.

Benz: Then, there is also the issue that we're all subject to limits on how much we can put into these accounts on a year-to-year basis. If you yank it out, you won't be able to put all that money right back in.

Jaconetti: Absolutely. That's an important feature of having this opportunity for tax-advantaged growth--you actually have limits. So, what would happen is somewhere down the road people always say, "When I have more money ... when I have a bonus coming in, I'll put it back." And they actually don't have the opportunity to put it back unless they are contributing well below the limits. So, it's important to know that you can't just always put those monies back if you find yourself in a better financial situation in the future.

Benz: From the standpoint of early withdrawals, Roth IRAs look potentially a little better. Let's talk about that. You can't take out your whole Roth IRA balance, but it might be a little more advantageous if you need to do a raid of something to use those Roth IRA assets. Why would that potentially be better?

Jaconetti: Yes, absolutely. With Roth IRAs, you can take out your contribution. Any monies that you contribute each year, you could take that out tax-free and penalty-free at any time. So, it really is a huge advantage, especially if you just need the monies for a short period of time. If a true emergency arises, being able to have access to that money penalty- and tax-free is very advantageous for investors.

Benz: Some investors who need emergency funds may find themselves in the situation where they have a 401(k) and they've also got a little money in a Roth IRA. If I'm in a worst-case scenario where I need some money and I don't have a sufficient emergency fund, how do I decide which of those things to tap first?

Jaconetti: I would definitely say do the Roth IRA contributions first. The reason why is obviously no penalties or taxes. Then, I would say for the 401(k), you could consider taking a loan. If you take a loan, you don't pay penalties or taxes. You do have to pay that money back and you do pay interest, but you're paying interest to yourself. So, it's a good way to get monies, especially for people who don't have as many contributions to a Roth IRA yet. So, for someone like that, usually a 401(k) has more money in it available to them. So, it is definitely a good way for them to be able to tap into it, and there's also the fact that you can put the money back. So, it's not like other plans where you won't be able to put it back. If you take a loan, you will repay it usually over about five years.

Benz: And you pay the interest to yourself as well.

Jaconetti: Exactly.

Benz: The big downside to a 401(k) loan, though, is--

Jaconetti: It's tied to your employment status. So, if you are with your employer and, for some reason, you leave your employer, you typically have to pay the loan back sometimes within 60 days. That could be a little bit difficult, because if you needed the money in the first place, you may not have the money to be paying it back that quickly.

Benz: It may be tied up somewhere where you can't access it.

Jaconetti: Exactly.

Benz: Let's talk about kind of a queue that investors could use to decide where to go for emergency cash--a sequence of withdrawals from best-case scenario to worst-case scenario. Can you segment those avenues?

Jaconetti: Sure. Hopefully, people will have an emergency fund. That would always be the first place to go. Typically, the emergency fund is in a money market or checking accounts. It's somewhere where there would be no tax implications for taking it out; it's easy for them to access. That would really be the first place.

If they need significantly more than the amount they have in their emergency fund, they should maybe consider a home-equity loan. You should really try to avoid taking anything from retirement savings as long as possible. If someone did need something from their retirement savings, we would first go to the Roth contributions. There would be no penalties or taxes on taking those. Then, I would say maybe the last resort would be the 401(k) loan--more because you could have to pay it back sooner if you change employment status. The more you can let things grow tax-deferred or tax-free, the better.

Benz: Colleen, thank you so much for being here to share your insights.

Jaconetti: Thank you.

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