Emergency funds are a ‘security blanket’ for 401(k) savings: Vanguard

Having an emergency fund can greatly impact your retirement savings in the long run, especially for those with fluctuating incomes, such as hourly workers. According to Fiona Greig, the global head of investor research and policy at Vanguard Group, emergency funds act as a safety net, preventing individuals from dipping into their retirement accounts for unexpected expenses.

Research conducted by Vanguard shows that 401(k) investors with at least $2,000 in emergency savings are less likely to take out loans or withdraw funds from their retirement accounts prematurely. In fact, they are 19 percentage points less likely to take a 401(k) loan and 17 points less likely to withdraw funds for financial hardships compared to those without emergency savings. Additionally, job-switchers with emergency funds are 43 percentage points less likely to cash out their 401(k) accounts.

Greig emphasizes that emergency savings play a crucial role in protecting retirement savings. Individuals with emergency funds tend to save a higher percentage of their income in their 401(k) accounts compared to those without such funds.

401(k) “leakage,” which refers to early withdrawals from retirement accounts, is a major concern for policymakers. Withdrawing funds early can lead to tax penalties and result in missed investment opportunities. The Employee Benefit Research Institute estimates that there could be an additional $2 trillion in savings in 401(k) plans over a 40-year period if individuals did not cash out their accounts prematurely.

Hourly workers, in particular, are at a higher risk of tapping into their retirement savings early due to their volatile incomes. Greig notes that hourly workers are less likely to have emergency funds and are more prone to using their 401(k) savings for immediate financial needs.

To build an emergency fund, financial planners recommend setting aside enough money to cover three to six months of expenses. This can be achieved by diverting a small amount of money from each paycheck into a high-yield savings account or money market fund. Automating savings through employer deductions or automatic transfers can help individuals consistently contribute to their emergency fund. Additionally, saving at least half of any unexpected windfalls, such as bonuses or tax refunds, can further bolster emergency savings.

By prioritizing the establishment of an emergency fund, individuals can safeguard their retirement savings and better prepare for unforeseen financial challenges.