Should I build an emergency fund or invest for retirement?
My company has gone through several rounds of layoffs. Although, I already have a comfortable (6+ month) emergency fund, I decided to stop the after-tax contributions to my 401K, which is 7% of my paycheck, in order to further beef up my emergency fund in case I should find myself out of work in the near future. My intention has always been to invest the differed contributions once things seem to have turned around; however, I only recently heard that you can take hardship withdrawals from your 401K in times of need. Would I be better off continuing to defer my after-tax 401K investments in order to temporarily beef up my emergency fund, or should I re-establish after-tax contribution with the understanding that, if my work situation were to change, I may need a hardship withdrawal from my 401K should I exhaust my emergency fund?
This depends on a number of factors that aren't disclosed here, so you might want to consider a full deep-dive with an advisor before taking any recommendations based on incomplete information. Nonetheless, there are several factors to consider.
Six months' of emergency fund is a great start, but I often recommend that clients have a full year's worth of income in liquid (or mostly liquid) assets. This provides a larger buffer for unexpected events, and it would help you confidently avoid any bad debts that could wreak havoc on your planning. There are obvious benefits provided by 401(k) such as tax deferral and systematic savings, which can improve overall ROI and lay a base for healthy savings habits. However, I am often puzzled by the assumption or implication that retirement savings can only be achieved in 401(k), IRA or similar accounts. If you are disciplined and have a well-defined plan, then you can easily use after-tax dollars in a regular brokerage account to invest for retirement without locking yourself out of your funds in the short term. Obviously you give up the benefits of tax deferrals, but it might be worth considering a more balanced approach to tax exposure anyway.
Many of my clients have the goal of minimizing the change in income from their working life into retirement, so they question the assumption that you'll necessarily be in a lower tax bracket. This might not be feasible for everyone, but it does seem odd to create aspirations that necessitate downsizing. Moreover, uncertainty about future tax rates inhibits any definitive comparisons between current and future tax liabilities. We simply do not know how what the government will require from citizens in the future, and historical analysis indicates just how wide the range could be. That is not to say we should anticipate materially higher rates, but we have to accept that we do not know this important piece of the puzzle, and diversification is usually recommended in other areas of financial planning to combat uncertainty. This is especially relevant if you are a growth investors, because qualified withdrawals from 401(k) accounts would be taxed as regular income rather than the capital gains rate that would otherwise apply to realized gains from appreciation. That could wind up being a massive difference, all for the sake of deferral on accumulation.
If you have a genuine concern that you'll face a liquidity problem in the next year, you should understand that further contributions to the 401(k) are going to reduce your potential liquidity.
A six month emergency fund is pretty good.
Since you mentioned after-tax contributions, are you eligible to contribute to a Roth IRA account? A Roth IRA would give you the ability to save up to $5,500 ($6,500 if age 50 or over) and the flexibility of withdrawing contributions without penalties.
You didn't mention, but if you have any credit card or unsecured debt you might want to divert your additional savings that way while you are working. Going into a layoff debt free will help your emergency fund last longer.
It is always good to have at least 6 months to 1 year of living expenses in an emergency fund (savings account). You should think about taking hardship withdrawals as a measure of last resort since you are essentially pulling yourself out of a current hole, but creating another problem down the line (not enough money for retirement).
I would recommend that you maintain some type of savings going into your 401(k). The uncertainty around layoffs could go on for multiple years, which are multiple years of compounding interest not happening for you. This is not a good thing. You should also go through your personal monthly budget to see where you could potentially shore up some of your monthly expenses that may be deemed as unnecessary. Certain expenses are non-discretionary, but you get the point. Should you lose your job and exhaust your emergency fund, then you can start taking hardship withdrawals. Because you already have 6+ months of a buffer, I would say that you are already in decent shape. If you had no emergency fund, then I would say that you need to make that a priority over the 401(k).
I think you should beef up your emergency fund, maybe even give yourself two years worth of living expenses. The big advantage would be if you do lose your job, you could hold out for the right job, or even have time to start your own business.
The smaller the emergency fund, the louder the clock is ticking to settle for something if you are unemployed. Wouldn’t you hate to take a job you don't like, just because you depleted your reserve fund and have to start earning some money to pay your bills?
You should also give yourself the opportunity to stop working for people and become your own boss. Maybe you're getting fed up of wondering whether or not somebody is going to keep you. If you had a nice ample buffer put together, you could afford to get your ducks in line to give yourself maximum job security; self-employment.
I did this over 25 years ago, and haven't looked back.
This is more of a personal decision than determining which is more financially optimal. The biggest question you need to answer is how long do you realistically think it would take you to find a job making the same amount of money you do now if you get laid-off? Make sure you at least have enough cash in your emergency fund to cover that gap. If you feel apprehensive or are constantly thinking about the balance of your emergency fund, continue to add to it until you feel comfortable. At that point, go back to your 401(k) contributions.