Wednesday, April 22, 2009

Emergency Funds

In last weeks commentary, I discussed "6 Ways to Ruin Your Retirement Plans." In hindsight, I left out one very important item.

Let's call it #7: Emergency Funds (aka 'Rainy Day Money').

We all know about Murphy's Law. Something that can go wrong, will go wrong - sooner or later. Unfortunately, it often comes at a price. If you're fortunate enough to experience a lower end repair, cash flow will cover the expense. However, big ticket items require a different strategy.
Don't get caught in this financial dilemma.

Having emergency funds of 3-6 months of expenses is a cardinal rule when it comes to financial planning. Couples working in different industries can use 3 months as a target it's fairly unlikely they will be unemployed simultaneously. Individuals should shoot for 6 months as they are the solely responsible for household bills.

Since 2008, I've noticed a sea change in client behavior. Individuals and couples have apparently depleted emergency funds for everything from vacations to washing machines. While we could debate what constitutes an emergency? The bigger issue should be getting an emergency fund back in place. Granted, it takes time and discipline to build back up your rainy day account. But, sooner or later, another storm is going to come!

What happens in the meantime? Couples are turning to retirement money for emergencies. The somewhat convenient process of taking premature IRA distributions is becoming a ready source of cash. Unfortunately, it comes at a HUGE expense.

Premature distributions - before the age of 59 1/2 - are taxed and penalized by the Internal Revenue Service (IRS). For example should an individual request $10,000 distribution from their IRA account, the IRS will impose a 10% ($1,000) early withdrawal penalty AND consider the full $10,000 as ordinary income when you file your 1040 tax return at year end. Assuming you are in a 30% tax bracket, this equates to a $4,000 (40%) tax bill at the end of the year.

Let's step back a minute and analyze this from an economic point of view. Everything in life is a compromise, or at least a trade-off. Financial decisions are no different. Would you borrow money at a 40% interest rate AND jeopardize your own retirement? When put this way, I believe most of us would answer 'No'. It's simply too expensive.

So, why do we tap into retirement money when financially pinched? Probably convenience. But, you would be better served to borrow money from a bank or even get a credit card advance should emergency funds not be available. Both come at a significant cost reduction AND don't effect your retirement assets.

At the end of the day, we all strive to make smart financial decisions. Don't let a short term need derail your retirement plans. Make sure you have an emergency fund (aka 'Rainy Day Money').

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