You’ll often hear that one of the best things you can do for your finances is start saving for retirement at a young age. If you begin funding an IRA or 401(k) in your 20s, you may have 40 years for your money to grow and benefit from compounded returns.
But while it’s crucial to save for retirement, there’s another type of savings you should tackle before focusing on your IRA or 401(k).
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Your emergency fund should come first
Unexpected expenses are a part of life. Whether it’s a major car repair, an expensive medical bill, or a sudden job loss, emergencies can happen when you least expect them.
Without an emergency fund, you may have to rely on credit cards or personal loans to cover those costs. But high-interest debt can quickly become expensive, making it harder to save for long-term goals.
That’s why you absolutely need an emergency fund to deal with life’s hiccups. Experts often recommend socking away enough money to cover three to six months’ worth of bills and keeping that cash in a high-yield savings account. That way, your emergency fund can’t lose value, and you should have instant access to it whenever you need it.
Now you may be thinking, “Well, if I hit a snag, I’ll just tap my IRA or 401(k).” The problem, though, is that these accounts impose a 10% early withdrawal penalty for taking distributions prior to age 59 and 1/2. An emergency fund in cash won’t do that.
Funding both at the same time could make sense
While your emergency fund should generally take priority over retirement savings until it’s complete, the one exception may be if you have a 401(k) plan through your job with a generous employer match. In that case, not contributing means giving up free money.
If you’re looking at a robust match, you may want to contribute to your 401(k) up to the point where you can snag your free employer cash in full. From there, put the rest of your savings into an emergency fund.
You should also know that the three- to six-month guideline is just that. If you aren’t committed to many expenses (maybe you’re a college grad who’s living at home rent-free), a two-month emergency fund may suffice. On the other hand, if you’re the sole breadwinner in your household and have a unique job that would be hard to replace, a nine- or 12-month emergency fund may be more suitable for you.
It’s a great and important thing to save for retirement, but your near-term needs should come before your long-term needs. If you solidify your emergency fund, once that’s done, you should be in a stronger position to focus on long-term savings and building wealth through investing.
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