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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?

Retirement, Investing, 401(k), Taxes
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May 2017

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.

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