Improving retirement readiness: The strategic role of emergency savings accounts

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Devin Miller
February 14, 2024

When it comes to planning for your financial future, retirement readiness is a critical component. Your level of preparedness for the post-employment phase of life will determine how much freedom and peace of mind you experience once you step into retirement. Because after your regular income ceases, financial stability becomes increasingly important. 

A critical but often overlooked component tool in becoming ready to retire is an emergency savings account (ESA). Also known as an emergency fund, it serves as a vital buffer that helps safeguard your retirement funds against unforeseen short-term financial emergencies.

Understanding the strategic role that ESAs can play in helping improve one’s retirement readiness begins with exploring the complementary relationship between short-term emergency savings and long-term retirement planning. 

ESAs as a foundation for financial stability

A robust emergency fund not only serves as a safety net to protect against unexpected financial setbacks, but it also plays a crucial role in preserving retirement funds. The fact that 63% of Americans are unable to cover a $500 expense, according to Bankrate, underscores the precarious situation that many face without an adequate emergency fund in place. 

When a financial emergency does arise, like a job loss or car repair, individuals without an ESA often turn to their retirement accounts to cover the costs, which can easily disrupt their long-term financial goals.

Mitigating early withdrawals from retirement accounts

Early withdrawals from retirement accounts carry notable risks: 

  • Reduced principal in the retirement fund, which could have accrued interest over time 
  • Incurred penalties and taxes, which further depletes the retirement savings

In 2023, 12.6% of Fidelity 401k plan participants borrowed or took hardship withdrawals from their retirement account​​. Moreover, 37% of 401(k) plan participants took out a loan during a five-year period, according to the National Bureau of Economic Research. This trend to borrow from retirement funds for financial emergencies highlights the dire need for alternative financial buffers.

A well-funded ESA acts as this much-needed buffer. By providing immediate access to funds during a crisis, ESAs reduce the need to tap into retirement savings too early. A large majority (80%) of employees who were auto-enrolled in their workplace retirement plan reported starting to save for retirement sooner than if they’d opted in voluntarily, and increasing their savings rates significantly (65%), found the Principal Financial Group.

Add to this data from BlackRock showing individuals with a robust ESA are 70% more likely to contribute to their retirement plan — and it’s clear that a solid emergency fund is a critical tool for retirement preparedness. 

Building a holistic financial plan with tax efficiencies in mind

In an ideal world, a comprehensive financial plan should combine short-term emergency savings and long-term retirement savings while keeping tax efficiencies in mind. This approach not only secures your financial present but also helps establish your financial future.

When integrating short-term and long-term financial goals, it's important to understand how to strategically allocate funds between Emergency Savings Accounts and retirement accounts. Here are two considerations:

  • Contributions to ESAs that are part of a workplace retirement plan (particularly through Secure 2.0 Act provisions) can typically be made on an after-tax basis. This means that withdrawals from these accounts, usually for an emergency, are tax-free​​.
  • Many retirement accounts, like traditional IRAs or 401(k)s, offer upfront tax benefits. Contributions to these accounts tend to be tax-deductible, which lowers your taxable income in the contribution year. But keep in mind that withdrawals during retirement are taxed as ordinary income. 

Balancing contributions to both types of accounts can optimize your tax situation both now and in the future.

Understanding the tax advantages associated with various types of ESAs and retirement accounts is crucial. For example, Roth IRAs and Roth 401(k)s offer tax-free growth and tax-free withdrawals in retirement, which can be particularly advantageous if you expect to be in a higher tax bracket in the future. 

Leveraging these tax-efficient strategies involves aligning these strategies with your overall financial goals. To maximize savings and minimize tax liabilities, consider the following strategies:

  1. Diversify your tax strategies. Just like investment diversification, tax diversification can be beneficial. Having a mix of Roth and traditional retirement accounts allows you to manage your tax liabilities more effectively both now and in retirement.
  2. Consider your retirement income plan. Figure out your expected income sources in retirement, like Social Security benefits and pension income, and how they'll be taxed. This will help you decide the best type of accounts to contribute to during your working years.
  3. Take advantage of catch-up contributions. If you're over 50, use catch-up contributions to boost your retirement savings in a tax-efficient manner.
  4. Review annually. Tax laws and personal circumstances change over time. Regularly review your financial plan, preferably with the guidance of a financial services professional, to ensure you’re utilizing the most tax-efficient strategies available to you.

Adapting ESAs to evolving life phases

Adapting ESAs to different life stages and financial goals is an important aspect of a long-term financial strategy. As you go through various phases of life, your financial needs and goals will inevitably shift. Here are four considerations when thinking about shifting your focus towards retirement savings:

  • Having a well-funded savings account
  • Moving into a later career stage (ages 40s-50s)
  • Availability of employer-sponsored retirement plans
  • Tapping into the power of compounding interest

Becoming more educated on the nuances of managing one’s ESA can help empower people to make informed decisions about contributions and withdrawals as life circumstances evolve. Continual learning and adaptation in financial planning helps individuals become well-equipped to face financial challenges and opportunities at each stage of their life.

A secure retirement starts with emergency savings

ESAs play a crucial role in improving retirement readiness by preventing the need to prematurely withdraw from retirement savings. This helps preserve these funds for future use when people need them most. By proactively integrating ESAs into a long-term financial plan, individuals can ensure a more secure and stress-free retirement. The key takeaway is clear: incorporating ESAs isn’t just a wise financial move in the short term, but it’s a strategic step towards a stable and comfortable retirement.

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