Can Your 401(k) Be Part of Your Emergency Fund?

April 11, 2013

One of the results from our recent research report that has gotten a lot of attention is that we saw an increase in the number of employees’ accessing their 401(k) balances through loans and hardship withdrawals from about a quarter in 2011 to about a third in 2012. The conventional wisdom is that this means employees need to do a better job with money management and in particular, building an emergency fund of at least 3-6 months of necessary expenses and maybe even more. For someone just starting out, I think this is absolutely true. 

Yet I often talk to people who have several hundred thousand dollars in a 401(k) that they can borrow from but just a few thousand dollars in their savings account. Would it make sense for them to suspend their 401(k) contributions in order to accumulate more savings outside their retirement plan? Not necessarily.

If they have an emergency that requires more than what they currently have in savings, let’s take a look at each of the main downsides of borrowing from their 401(k) to cover the difference. One is that they lose the potential growth on that money. But by keeping a large cash balance, they lose that growth each and every year. Second is that the market may be down. But that’s an argument for having a balanced portfolio in their 401(k). In fact, even cash is likely to earn more in the 401(k), which provides tax benefits and may offer higher-yielding stable value funds. Finally, if they leave their job, they’ll have to pay a tax and possibly a 10% penalty on the outstanding loan balance after 60 days. But they’ll have to pay the same tax on any money they don’t contribute to their 401(k) and having even one good year like last year can more than make up for that 10% penalty.

So how do you know when you can safely think of your 401(k) as the bulk of your  emergency fund? I would say you should have at least 4 times 3-6 months’ of your necessary expenses. That’s because if your account loses half its value, you can still access 3-6 months’ worth of expenses by borrowing up to half of the remaining balance (up to $50k, which is the most that plans generally allow).

Keep in mind that you’ll still want to have something in savings outside the 401(k) to cover smaller short-term cash needs and avoid the fees and delays of a 401(k) loan. In addition, this doesn’t mean that your 401(k) should be thought of like an ATM. 401(k) loans should be reserved for paying off high interest debt and for actual emergencies (wanting  a bigger screen tv doesn’t count). After all, the real purpose of your 401(k) is to avoid the ultimate emergency: not having enough money for retirement.