An Emergency Fund Shouldn't Take a Year

Beth is 30 years old and debt-free. Should she stop her 401(k) contributions for a year to save up her emergency fund?

QUESTION: Beth in Pennsylvania is 30 years old and debt-free. Should she stop her 401(k) contributions for a year to save up her emergency fund?

ANSWER: Yes. I surely do. It shouldn’t take you a year, but if you have to for a whole year, that’s fine. I recommend you stop investing until you are debt-free except your home and have your emergency fund in place. In some cases, that might take three or four years to do both of those things.

But here’s the deal: If you have no emergency fund but you’re funding your 401(k), when you have an emergency, you know what you’ll do with your 401(k)? You will cash it out because it becomes your emergency fund. And when you cash your 401(k) out early, they charge you a 10% penalty—the government does—plus your tax rate. So you’re going to get smacked upside the head with about a 40% hit on what money you pull out. Pull $10,000 out, the government’s going to take $4,000 of that. Not a good plan.

So you need an emergency fund in place before you start your investments because your investments otherwise will become an emergency fund. That simple.

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