As I write this I am on an airplane on my way to Dallas, TX to talk to a group of 401k plan participants. I’m thinking about what I will say to them such as the reason for saving for retirement, the features and benefits of their plan, the power of compounding earnings, and so on and so forth. What I REALLY need to be telling them, is that as important as it is to save for long term needs such as retirement, it is equally important to be saving for short term needs. I recently heard a statistic that a large percentage of the US population will need to borrow to cover an expense of greater than $400. This means to me that a large percentage of the US population has less than $400 in short term savings. It also means that for larger expenses such as new tires for your car, a surprise repair bill, or some appliance replacement is most likely going on a credit card or some other line of credit. In this post, I am going to explore why it is vitally important to save for the short term and discuss how much you should be saving.
In the case of an emergency where are you going to get the money? If you have little money in short term savings and you have an emergency situation such as having a furnace break down in the middle of winter, where are you going to go to pay for the new furnace? One of the worst ways to pay for that emergency is to take money from your long term savings such as a 401(k) or IRA. Your long term savings is just that, long term. Your long term investment strategy should be utilizing compound earnings to help the account grow. If you take the money out of the account, even temporarily, you are limiting the opportunity for compounding to work for you. In addition, you may be subject to tax and or penalties for withdrawing these dollars. Let’s look at an example. John, age 35, has $50,000 in an IRA and takes $10,000 out to pay for his new furnace. If he is in a 25% federal tax bracket, he will end up with only $6,500 of his distribution due to taxes and a 10% early withdrawal penalty. On top of that, he will not have that $10,000 working for him using the power of compounding. His lack of a short term savings vehicle has now cost him an extra $3500 plus lost earnings potential.
Let’s look at another scenario. If John has a loan option available, he can borrow the money from his 401(k) and pay it back with interest. Sounds good, right? Well let’s see. John takes the $10,000 loan from his 401(k) over a 5 year period. He stops contributing to the 401(k) to adjust for his new monthly payments. He pays the loan off in 5 years and then starts contributing again. By not contributing and missing the compound earnings on John’s loan amount, Johns projected account value is much less than it should have been if he hadn’t taken the loan.
I will always suggest trying other means of financing before you borrow from your 401(k) or take and emergency withdrawal, but credit card debt and other loan debts are eating away at your earning power. Anything that you are paying interest on is costing you additional dollars. The sooner you can get to a reduced debt state and begin growing your short term savings, the better off you will be.
So how much should you have in short term savings? I once read “How to be Your Own Stock Broker” by Charles Schwab where he said to have 6 months of salary saved in a short term savings vehicle. I was pretty young at the time and remember thinking that seemed like a lot of savings. Now that I’m older I realize that it’s really not that much and might not even be enough for some people. When I put together financial plans for my clients, my minimum recommendation is to have 6 months of expenses in short term savings. I have recommended as much as two years for certain occupations. It just depends on how risky your business is and how long it might take to recover from financial hardship. If you are a specialized occupation and that specialty is somehow no longer needed, how long will it take before you can get a new job or start a new career. This seems far-fetched, but is it? I wonder when the day will come that Amazon takes over my career specialty.
So there you have it, my 2 cents on why you should have a short term and a long term savings. I bet my group of participants are going to get an earful on the matter during my speaking engagement this afternoon.