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Throwing money into funds on rainy days can further strengthen household retirement prospects in the future, particularly for hourly workers with inconsistent income flows.
Emergency funding is a “security blanket,” says Fiona Greig, global head of investor research and policy at the asset manager Vanguard Group.
That’s because they’re providing cash buffers to people who might otherwise raid their 401(k) accounts and pay unexpected costs in the short term, she said.
According to a New Vanguard study, investors with 401(k) emergency savings with at least $2,000 in emergency savings are less likely to tap on their retirement plans than investors without rainy day funds.
Specifically, they are 19% points, and are unlikely to take a 401(k) loan, while 17 points are unlikely to withdraw 401(k) funds due to financial difficulties, Vanguard found.
Leaving a job is another trigger that allows workers to access 401(k) savings before resignation. According to Vanguard, job switchers with emergency funds are less likely to cash their 401(k) accounts than their 401(k) accounts for 43% points.
“Emergency savings protect retirement savings,” Graig said.
Retirement savers with emergency funds save most of their income at 401(k). At 401(k), Vanguard found that it was 401(k) compared to those without them.
401(k) “leak” is a major concern
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Policymakers view the 401(k) plan, particularly the so-called “leaks” from cash-outs – as a major obstacle to retirement security.
Early withdrawal of 401(k) assets generally involves tax penalties and shortchange investors, and is undermined from long-standing investment returns on the funds they withdraw, experts said.
Employee Benefits Institute estimated in a 2019 paper that if workers do not cash their accounts early, they will have around $2 trillion extra savings in a 401(k) plan over 40 years.
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According to Vanguard’s Greig, leaks are particularly a major concern for hourly workers.
Hourly workers are less likely to have emergency funds and are more likely to tap 401(k) savings earlier than paying employees, Graig said.
(She said that not only does it tend to earn less money, both hourly wages and workers, but also to earn less money.)
Workers per hour have more unstable incomes, Graig said. Without the emergency buffer, she said, if cash flow unexpectedly drops, she might need to tap 401(k).
How to build an emergency fund
Ideally, the household would have enough money to cover three to six months of expenses (such as mortgages and groceries) with the emergency fund, said Carolyn McClanahan, a Jacksonville, Florida-based certified financial planner and member of CNBC’s Financial Advisors Council.
But anything can be useful if it’s made enough for the household to interact with. McClanahan said.
Financial planners generally recommend hiding emergency funds in conservative liquid accounts, such as high-yield savings accounts or money market funds.
Cash-bound savers can start by detouring the emergency fund from $10 to $25 per salary, McClanahan said.
“Money would be worth something before you grow it and you know it,” she said.
According to McClanahan, workers should automate their savings by asking them to send a certain amount to a designated emergency account for each wage period or by setting up automatic transfers from their bank accounts.
Workers should also try to save at least half of their financial wind drop, such as bonuses and tax refunds, she said.
