Emergency Fund or Retirement First?

Posted by Jill on July 7, 2010

A friend of mine recently asked me a question:

“Should I be putting extra money into emergency savings or an IRA at the end of the month?”

Allocating funds and/or setting priorities for saving is something that many people struggle with.

Order to Prioritize Your Savings

  1. Most experts will agree that first and foremost you should fund a 401(k) or other employer-sponsored retirement account up to the point of match – you’re maximizing your return in this way because the match is free money. If you don’t receive a match, skip this step and save for retirement in an IRA instead.
  2. You should then work to build your emergency fund. Advice varies on the amount, but 3-6 months of non-discriminatory expenses is safe for most people.
  3. If you have big expenses coming up, such as a new car, a wedding, a big trip or something similar, set aside some portion of your savings to fund that future spending – this helps smooth your spending over the course of a year and is much better for your budget than incurring those big expenses all at once.
  4. Next, you should contribute to a Roth IRA if you’re eligible. If you’re not, you can contribute to a traditional IRA and do an immediate Roth IRA conversion.
  5. Finally, and only once you are debt-free AND satisfied with your savings in items 1-4 above, you might consider investing in taxable accounts.

Items 3 and 4 can and should be done somewhat concurrently – you need to strike a balance between short-term goals and long-term security. How much you should put towards each depends on how much of your salary you are able to save, and whether you’ve contributed to an employer-sponsored plan.

If you did contribute to an employer-sponsored plan, you can choose to save as much as you need for your short-term goals, and put the rest towards retirement. You can instead choose to save 10% of your salary towards retirement, and put the rest towards short-term goals. Or, if you’re in the enviable position of having more than enough to meet all your objectives, you can split the money right down the middle, putting half away for retirement and the other half towards those big-ticket items you’re saving for.

Circumstances Matter

The friend who asked me the original question is in college – chances are family and/or financial aid are paying for many of her big expenses, and her paycheck is more for daily expenses such as food and entertainment. She is also unlikely to have an employer-sponsored retirement plan. Finally, she is so young that contributing to her IRA now could have big payoffs down the road. So for her, I might tweak the standard advice – depending on exactly how much money she is talking, I might tell her to build an emergency fund of $1,000 or 3 months of the expenses she is responsible for, whichever is larger. Then I’d encourage her to contribute at least half of the annual limit to an IRA (preferably a Roth IRA). If she still has money left over, I’d likely recommend she split it, saving half for post-grad expenses such as furniture and work attire and putting the other half towards maxing out her IRA.

When Should You Pay Off Debt?

Advice may also change if you are trying to get out of debt, in which case you want almost no savings beyond a small emergency fund and employer-matched retirement savings. If you are single, or married with one spouse not working, the lone salary matters much more – so you might need a bigger emergency fund.

The point is, like so much else in the world of personal finance, there is no easy answer to the question of what to do with extra funds. Every situation is different, and every person has a different risk tolerance. Once you are debt free, do your best to balance investing for the future with planning and saving for shorter-term expenses – and of course work on building a buffer for emergencies. Next up, Should You Use a Roth IRA as an Emergency Fund?

What is your preference? Emergency fund, pay off debt, or retirement first?

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Comments to Emergency Fund or Retirement First?

  1. I like a small emergency fund and then I gravitate toward putting extra in my retirement account and toward the mortgage (my only debt is that and a student loan).

    The mortgage debt question is always a huge one. Ours is 5.25% and we have a small enough loan that it gives us no tax breaks (the standard deduction has always been higher). I split the extra between savings/investment and extra mortgage payments. It is a hard call, but there just isn’t a safe way to invest and be guaranteed 5.25% right now (plus I would need to net a higher rate to compensate for taxes taken out).

    I tend to be risky with my investments so I just look at putting extra toward my mortgage as one of my safer saving vehicles.

    Frugal Tips

    • Interesting perspective on paying off debt as a “safe” savings vehicle! Curious as to why you’re attacking mortgage vs. SL as it seems that SL would be both lower balance and higher interest. Always interesting to see why people prioritize differently – but as long as you have made a conscious decision to stick to a plan, you are doing better than most people!


  2. I agree with most of this article, but I think that first priority should be a small emergency savings (ie $500-$1000), then proceed with the recommended prioritization. I just know too many people with 0 savings, and then when something like ‘life’ happens it totally ruins them. 🙁

    Ian G

    • Thanks, Ian. Definitely important to make sure you have a little buffer for the “what ifs.”


  3. Emergency fund by definition must come first. In case of an emergency, you’d have to dip from your retirement contributions & pay taxes/penalties.

    One caveat would be if you would used your original contributions to a roth b/c you can withdraw that penalty free. BUT if you are counting that for an emergency, those funds are probably at some kind of market risk.


    • I agree with Howard. Roth IRA is a no-brainer for my family. Our income is small enough that we pay no net taxes after credits, so our “after-tax” Roth deposits and earnings aren’t taxed ever.
      The Roth loophole allowing withdrawal of principle means it’s also a viable emergency fund, too. We do our non-work retirement investing with Vanguard, and we have a money market fund and two bond funds on tap for emergency use with check-writing privileges, or a bank transfer takes about a day.


  4. I don’t understand the emergency fund thing. There I’ve said it. I know if PF blogging circles that’ blasphemy but if your’re paying more than the 2% interest on your credit card. Your are worse off every month buy having your “emergency fund”. If you need the money just use the credit card again. I know there are a million bloggers out there outraged at the moment. A credit card is not a crack pipe! If you made the decision to be debt free you will do everything possible NOT to use the credit card.

    Saving for retirment is a must for your very first paycheck. No one else is going to take care of you.

    Benjamin Bankruptcy

    • Thanks for the perspective – you are right in that there is much debate over this strategy! I think one important thing is to have a clear understanding of what constitutes an emergency – in that case it won’t be as easy to backslide into credit card debt because your friends are going to see a concert or something!


  5. Absolutely you should fund retirement first.
    Your kids don’t have to go to college, and you may not have the funds for it anyway.

    One thing which we ALL have to face is having enough money in retirement for a source of income, and being able to keep up with rising costs. What if you are ‘retired’ for 20-25 years or more?

    This is one of the topics in my upcoming book, Help! My 401(k) Has Fallen – And Must Get Up! College or retirement is always an interesting question, but in most situations, retirement trumps college.

    Dean Voelker

  6. I disagree with @Benjamin Bankruptcy – I think an emergency fund must be first, with the caveat that first you must decide exactly what constitutes an “emergency” so that you don’t turn it into a “rainy day fund” and empty it prematurely. Hopefully you will never need to use it at all, but when you experience an unexpected loss of income for whatever reason you will be glad it’s there. Not all emergency type expenses can be put onto a credit card as Benjamin suggests, and once an emergency fund is funded you leave it alone – it won’t continue to be an expense.

    After the emergency fund then debt payoff vs. investment depends on how risk averse you are and what your returns vs. interest rates are. I like to balance both but lean toward debt payoff – it’s basically a guaranteed rate of return, as long as you don’t immediately turn it into more debt after one is paid off. I’ve never met anyone who paid off their mortgage early who regrets doing so.


  7. Lots of good comments! This is always one topic that is sure to inspire discussion. As I said to someone earlier, whatever works for you is the right way for you – having a plan is half the battle!


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