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6 Surprising Benefits of an Emergency Fund

Oct 23, 2018 4 min read Ben Gran

Key Takeaways

  • Most Americans can't afford a $500 emergency.
  • Emergency funds can do more than just pay for unexpected costs.
  • Benefits include improved work productivity, family relations, and retirement balances.

 

Having money set aside for a rainy day – also known as an “emergency fund" – is fundamental to achieving financial security. It's generally recommended to have three to six months' worth of living expenses in an easily accessible cash savings account. Unfortunately, far too many Americans do not have an emergency fund, putting them at risk for debt. A recent Prudential study found that 63% of Americans do not have enough savings to handle a $500 emergency.

 

 

If you're in that majority and are looking for some extra motivation to save, here are six surprising ways an emergency fund can benefit you:

 

1. Ensure the security of your future (retired) self

One of the lesser-known benefits of having an emergency fund is that it can help protect your retirement savings by preventing you from borrowing from your future self.

The Prudential study found that an average of 1.5% of total assets in 401(k)/IRA accounts “leaked" out each year (due to early withdrawals) – but this small percentage of lost assets added up to 25% less wealth in retirement. So that means if you have to withdraw $5,000 from your retirement savings this year to fix your leaky roof, it might result in more than $83,000 that you won't have in the future when you want to retire. Taking an emergency loan from your retirement account is too costly and risky – even a small amount of money today might jeopardize your long-term retirement plans.

If you have no other choice but to take an early withdrawal from your retirement plan, there are smart ways to lessen the blow to your long-term retirement savings. Such as protecting your pre-tax and Roth after-tax contributions to preserve your tax-advantaged savings sources. To do this, consider making incremental after-tax (non-Roth) contributions into your plan, thereby building up a source of savings that is accessible in case of emergency.

 

2. Be more successful and smile more

According to the Prudential survey, 30% of employees report that issues with their personal finances have been a distraction at work. Having an emergency fund helps you focus on your job instead of stress about paying your bills. Ironically, if you're not worrying about money all the time, you have more energy to concentrate on making more money! Saving for an emergency fund is an investment in your own productivity and career success. See if your employer offers any programs aimed at helping workers establish an emergency fund.

 

3. Protect your credit, save your sanity

If you already have a few months' worth of emergency savings in the bank, you don't have to put that home repair or car insurance deductible on your credit card. This can help you avoid the stress of maxing out your credit card or other lines of credit, or taking on high-interest debt such as a payday loan. The Prudential study found that 12 million Americans take out payday loans each year, accruing $9 billion in loan fees. High-interest debt can be a cancer on your finances; if you're not able to pay down the balance each month, it tends to get bigger as time goes by. This leads to a cascade of other money woes, such as late fees and hits to your credit score. Plus, being in debt can cause people to lose sleep, experience anxiety, and can undercut performance at work, as in #2. It's best to stay out of high-interest debt in the first place by "loaning yourself" money from your emergency fund.

 

4. Avoid the Tax Man

Some people might assume their well-funded retirement plan offers an emergency buffer for hard times, so they forgo an emergency savings account that is easily accessible (without penalties or tax consequences). However, using your 401(k) or another tax-advantaged retirement plan as a piggy bank can bring significant tax consequences. If you make early withdrawals from your retirement accounts before you reach the age of 59 ½, you will incur a 10% early withdrawal penalty on the taxable portion of the money withdrawn. If you take the money from your pre-tax savings, you’ll pay income tax and the 10% penalty on the total distribution when you withdraw. Whereas, if you take money from your after-tax savings in the plan, you’ll pay neither income tax nor penalty on the money you contributed. Rather, you’ll only pay income tax and the 10% penalty on the earnings withdrawn. It's better to have a source of liquid, immediately available emergency savings, preferably in a cash savings account funded with after-tax dollars.

 

5. See bigger gains from your retirement savings

Having an emergency fund has another surprising benefit: it can help people feel more confident in investing in stocks as part of their retirement strategy. Many people, especially younger investors, make the mistake of being too conservative in allocating their retirement investments. They're afraid to lose money, so they put too much of their retirement savings into low-yielding bonds or cash. If you have a stable emergency fund to handle your short-term financial goals, this can give you additional risk tolerance to invest in potentially higher-yielding stocks in your retirement accounts.

 

6. Have more fun at family reunions

High-interest payday loans are not the only form of "risky" debt. According to a survey from Finder.com, each year, Americans borrow approximately $184 billion from their family and friends, with an average loan amount of $3,239. Borrowing from family might sound like an easy fix, but what if you can't repay the loan? Mixing money and family can sometimes lead to hard feelings and financial trouble for the lender. Don't complicate your most treasured relationships with money trouble. It's better to have an emergency fund of your own so that you don't have to go asking Mom and Dad (or aunts, uncles, and cousins) for help.

 

What you can do next

Take a close look at your monthly budget and calculate how much emergency savings you should have to afford three to six months of living expenses. You can use this Slice a Budget tool to figure out how to strike the right balance between spending and saving to achieve your goal.

 

Ben Gran is a freelance writer based in Des Moines, Iowa. He writes about personal finance, financial services, technology, and business trends.

 

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