Should I Add Money to My Retirement Plan or Build Up My Emergency Fund?
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As you work to build your retirement savings, you might wonder whether you should fund other types of accounts as well. While saving for retirement is important, it's also wise to make sure you're building a rainy day fund and an emergency fund (which are, in fact, different). How much you choose to allocate to each account is up to you and will likely change over time, but here are some things to consider as you budget for your savings contributions.
Priority #1: Rainy day savings
Your first priority should be setting up a rainy day fund that can cover unexpected expenses that fall outside your budget: a minor car accident, a home repair or a trip to the vet, for example. A rainy day savings account differs from an emergency fund in that it helps you pay for temporary, one-time expenses that are less significant than those covered by your emergency savings.
Fewer than two out of five Americans have savings for minor unbudgeted expenses. Without a sufficient rainy day fund, even the most budget-conscious person can be hit hard by an unexpected car repair or ER visit. Even a manageable amount, like $1,500, is a good place to start for a rainy day savings account. The funds should be readily accessible (for example, in a savings or money market account), FDIC insured and not commingled with your retirement accounts. The balance in this account should be enough to help you get by in a pinch.
Priority #2: Emergency savings
Once you have funded a rainy day account, your next priority should be your emergency savings. Whether you experience a job loss (either yours or your partner's), a major illness or some other significant life event, you'll need savings to help get you through the drought.
Unlike a rainy day fund, your emergency savings needs to be a substantial amount of cash. For example, if you are single, you should save enough money to cover three months of your nondiscretionary expenses — the things you need to survive, including food, rent, health insurance and utilities. If you are married or if others are depending on you, consider setting aside at least six months of your nondiscretionary spending. These funds should be readily available — in other words, if you need to make a withdrawal, you should not be penalized. Just as with your rainy day fund, your emergency savings account should be FDIC insured and not commingled with your retirement accounts.
Always a priority: retirement savings
At the same time that you are socking money away for emergencies, you should also be saving for retirement. Both are extremely important for your overall financial well-being.
For example, if you were to lose your job and you did not have emergency savings, you might be forced to withdraw money from your retirement account, which could result in penalties, taxes and other negative consequences. At the same time, if you don't have enough money saved for retirement, you may not be able to stop working when you want, or you might have to radically change your lifestyle when you do. You might also have to dip into your emergency savings to help fund your retirement. That's why it's so important to contribute to your 401(k), 403(b) or other retirement savings plan regularly.
Other savings goals
Once you have your rainy day, emergency and retirement savings in place, then it's time to start prioritizing your other savings goals, such as paying for college for yourself, your children or your grandchildren; buying a house or vacation home; or buying a new car. You might think that saving for your child's college education needs to be a top priority — and it is important. But if the time comes and you don't have those funds, there are options, like student loans, to help you out. On the other hand, the only one who can pay for your retirement is you.