We’re often asked for tips on how to create a successful retirement. We think this such a great question that we’re devoting a new column to this topic. In each newsletter, you’ll find one “tip” we’ve found to be invaluable on the path to retirement victory. We hope you enjoy the information.
Tip #2 – Establish an emergency savings account BEFORE you retire.
If you don’t have an emergency savings account established, and at least $1000 saved, you may not be ready for the realities of retirement. Or at the very least, retirement may be more difficult for you to navigate. Here’s why.
Whether you’re nearing retirement, or happily retired, having an emergency savings account allows you to divert potentially damaging unforeseen events from derailing your finances.
For example, let’s say you’ve worked hard to minimize your debt and save for retirement. Then a major home repair pops up that you were not expecting, and you need to find $5000 to pay for it. You could put it on a credit card, but then the expense actually becomes worse, because of the additional interest you’ll be paying to the credit card company. For example, if your credit card has an interest rate of 20% and you make only minimum payments for 1 year, your $5000 bill just became $8418 with the added interest.
You can look at the math, and do your own, here: https://www.dinkytown.net/java/Debt2Amount.html
Let’s say you avoid the credit cards, and instead you take money out of your retirement savings to pay for the unexpected expense. No interest payments, right? Not exactly. If you are under age 59 ½ (with a few exceptions), you could face an IRS penalty as well as tax consequences, which very likely can add up to 35% additional cost to your withdrawal. So for your $5000 bill, you’d need to pull $6750 out of your account to potentially cover everything – more, if you’re in a higher tax bracket.
More often than not, the timing of this extra distribution causes more strain on the retirement nest egg than anticipated. Since you can’t time life’s emergencies, money that is needed urgently can force us to sell investments at non-ideal times in the market. This creates even more loss in growth potential than initially thought.
Bottom line: if you have an emergency savings account, you can pay the home repair bill while avoiding extra costs. You can then move on, leaving your future unharmed.
Tip #2b: …and practice how to use it.
As Dave Ramsey likes to say, “Christmas is NOT an emergency.” The purpose of an emergency savings account is to be a source of cash when the unexpected happens, so you don’t have to resort to credit cards, loans, or an additional withdrawal from your retirement savings accounts. Dipping into your emergency savings to purchase a wedding gift or new phone, or even to pay off a credit card, goes against the purpose of having the account in the first place. It’s best to stash the cash away and out of your mind, so you’re not tempted to spend it on a non-emergency.
How much you have in emergency savings is up to you. Most planners recommend having 3 to 6 months’ worth of expenses saved for emergencies. Some people feel comfortable saving more. Whatever you do, though, make sure you have something.
The emergency savings account can be both a lifesaver and a tool to help you build financial muscle. Saving takes both focus and discipline, but it is a habit worth developing: like exercise, it can make you healthier, stronger, and happier in the long run.
A qualified tax professional or independent legal counsel should review the tax implications of any securities transaction. This material is not intended to replace the advice of a qualified attorney, tax advisor, financial advisor, or insurance agent. Before making any financial commitment regarding the issues discussed here, consult with the appropriate professional advisor.