If you recently started your first job, or at least recently committed yourself to saving money, you’ve probably asked yourself this question: Should I contribute to my 401(k) or my emergency fund? Each is important in its own way, but if you have limited financial resources you may have to choose one over the other.
To help you with that task, we’re going to present both sides, and look at the advantages of each.
There’s no right or wrong strategy here. If you’re saving money in either account, then you’re heading in the right direction. But which way you will go will come down to individual circumstances.
The case for giving priority to your emergency fund
An emergency fund is the most basic of all savings plans, and where most new savers should start. Why?
You want to get out of the poor house.
Nothing brings a person closer to a sense of financial desperation than an empty bank account. That’s because a lack of very liquid cash reserves means that you’ll feel every bump and sharp turn on the financial road of life. If you have no liquid savings whatsoever, then beginning to build an emergency fund will be as important to your emotional well-being as it is to your financial stability. A 401(k) plan—as desirable as it is—is not a suitable emergency fund.
You want to fill the account with the most immediate need.
Setting financial priorities is important. Despite all of the benefits of a 401(k) plan, it’s intended to be a plan that will benefit you only in the very distant future. An emergency fund, on the other hand, works to provide for an immediate need. For example, if you need to replace the transmission in your car, an emergency fund can help you—a 401(k) plan can’t. Long-term financial planning is important, but you can never afford to ignore the present.
Your employment situation isn’t very stable.
The amount of liquid savings that have should be in inverse proportion to your level of employment stability. That means that an unstable employment situation requires more liquid cash.
This isn’t just about the stability of your job either. You also have to assess the stability of the field that you’re working in. A very stable job market will require fewer savings, since you can replace your job quickly. But if that isn’t the case in your industry, emergency savings will need to be a priority. The account should be large enough to pay your living expenses for as long as it will reasonably take to replace your job.
You’ve got a large debt load.
If you’re a recent college graduate and you have student loans, a new car loan, and some credit card debt, an emergency fund is critical. That’s because, in addition to your regular living expenses and your monthly debt payments, you will still have unexpected expenses. Unless you have a well-stocked emergency fund, you will meet those expenses by going deeper into debt. That won’t help your long-term financial outlook—even if you have a 401(k).
You’re not sure how you’d handle a large, unexpected expense.
This is perhaps the fundamental question in determining the importance of having an emergency fund. If you were suddenly facing a $3,000 medical deductible, how would you pay for it? If the answer to that question involves the use of credit, then an emergency fund has to be a priority.
Your budget doesn’t leave enough room to fund a 401(k).
There are so many reasons to participate in a 401(k), but if you are at a point where you are struggling to survive, as many twentysomethings are, you have to carefully allocate your money. If you live in a high-cost city, or you have a lot of debt, you may simply not have enough room in your budget to contribute to a 401(k). In addition, your tight budget means you need to fund a large emergency fund as soon as possible.
The case for giving priority to your 401(k)
While an emergency fund has its benefits, there are a number of circumstances in which you may want to prioritize funding your 401(k) first.
Your employment situation is very stable.
Yes, this is the same question that we asked in regard to an emergency fund. It is equally important in regard to a 401(k) plan. If your employment situation is very stable, it will be easier to make a priority out of funding the 401(k). That’s because you are less likely to lose your job, and therefore less dependent upon short-term savings. Retirement planning is, after all, a long-term proposition, and that is enhanced by a more stable employment situation.
Your employer matches your contributions to a 401(k).
Most employers provide some sort of matching contribution. A 50 percent match on an employee contribution of 6 percent is common (for a total employer contribution of 3 percent), but some employers are even more generous. A matching contribution is free money. If your employer offers it, it’s a strong reason to contribute enough to qualify for the maximum match.
There is one caveat here, and that’s vesting requirements. Most 401(k) plans require that you remain employed with the company for certain number of years in order to be vested. That’s when the matching contribution becomes fully yours. Prior to that, either some or all of the match will be forfeited if you leave the company for any reason.
If the plan requires that you work for the company for at least five years before you are vested, but the company is a revolving door in which most employees last no more than a couple of years, the vesting may never happen. Unfortunately, there are employers and even entire industries where short-term employment is the rule rather than the exception.
You have very little debt.
If you have very little debt, then you probably have more money available to invest for the long term, which is what you are doing with a 401(k) plan. The absence of debt means that…
- More of your income is available to put into a 401(k) plan
- It’s less likely that you will experience a short-term cash crunch, because your income is not being reduced by debt payments
You’re in a high tax bracket.
If you are in a high income tax bracket, then making contributions to a 401(k) plan can easily become a priority. Let’s say that for federal income tax purposes you’re in the 25 percent tax bracket (for 2016 this rate will apply if you are single and your income is between $37,651 an $91,150). Let’s also say that you are in the 8 percent bracket for your state income tax. That means that your combined marginal tax rate is 33 percent.
For a person in this situation, prioritizing 401(k) contributions is even more important. That’s because the contributions you make represent a substantial reduction in your income for tax purposes. And just as important, you can think of it as the federal and state governments subsidizing your 401(k) contributions, by effectively paying 33 percent of the amount you contribute.
The combination of the employer match and the federal and state income tax deductions can make contributions to a 401(k) plan too rich to pass up.
Your employer’s 401(k) plan has a loan provision.
Under IRS regulations, 401(k) plans can offer loans to employees for up to 50 percent of their vested balance, up to $50,000. If your 401(k) plan offers a loan provision (they are not required to under IRS regulations), this can serve as something of a backdoor emergency fund.
In this situation, it may be in your best interest to put as much in your 401(k) as early as possible. For example, if you put $10,000 into the plan in your first year of participation, you could gain access to a loan of up to $5,000. Taking out a 401(k) loan is not a great idea, but it might beat credit cards or other high-cost debt in an emergency.
Which route should you take?
In a perfect world scenario, you’ll be funding both an emergency fund and your 401(k) plan at the same time. Use our free interactive saving navigator to see if you’re able to do both, or get a personalized recommendation of where to save first. Try it now.
But the high cost of living could make that option unrealistic. This is especially true if you are young and trying to establish yourself in a new career field, as well as acquiring the trappings of the lifestyle you want to lead.
You’ll most likely have to choose to fund one account or the other. But as I said at the beginning, you’re on the right track if you’re saving money at all, whether that’s in an emergency fund or a 401(k) plan.
Also keep in mind that as you gain more skills and experience, your income will increase. As it does, you will soon be in a position to fund both accounts on a regular basis. But until then, choose to fund the account that works the best in your situation.