Why everyone should have both a 401(k) and an ESA

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Devin Miller
July 13, 2023

On January 1, 1980, new laws changed how employers can help employees save for retirement. The Revenue Act of 1978 included provisions for tax-free retirement accounts, which were called 401(k)s after the corresponding section of the Internal Revenue Code.

In December 2022, the SECURE 2.0 Act went into effect, and it implemented new rules and provisions around both 401(k) and emergency savings accounts (ESAs). These two types of savings accounts are critical for long-term financial health, and they are also quite different from each other in terms of growth and purpose.

What does the average employee need to know about 401(k)s and ESAs, and how they complement each other? Here’s a primer on each type of plan and why they work best in tandem.

Why might you want a 401(k) savings plan?

A 401(k) is just one type of retirement savings plan, though it’s one of the most common. Most 401(k) plan participants are set up through their employers, but you can create an individual 401(k) if you are self-employed.

There are some advantages to a 401(k) savings plan that set it apart from other options. Some have to do with taxes:

  • Contributions to a traditional 401(k) are made pre-tax and are tax-deductible, lowering your taxable income for the year
  • 401(k) earnings are tax-deferred; you won’t pay taxes on dividends or capital gains until you start withdrawing from the account at retirement

Another benefit to investing in a 401(k) is employer matching, which means the employer may match certain amounts or paycheck percentages that the employee contributes to the 401(k). In some cases, employers will profit-share and contribute a portion of company profits to employee retirement savings.

These advantages are one big reason why 401(k)s are such popular retirement vehicles: It’s easier to save more money at a greater rate with the tax breaks and employer matching.

A 401(k) account is intended to grow throughout your career, and the growth also compounds year after year, meaning that the earlier you invest and the more you contribute over time, the healthier your account will be at retirement. Any withdrawal made, especially early in the savings process, can therefore seriously undermine your overall retirement savings goals. It’s critical to leave the money you put in a 401(k) untouched and allow it to mature and expand.

Why should you have an emergency fund?

An emergency savings account (ESA) or emergency fund is a pool of money saved specifically for unforeseen emergencies and unexpected crises. Life is full of surprises, and not all of those curveballs are pleasant experiences! Cars break down, roofs leak, and a layoff or unanticipated job loss can throw anyone’s finances into turmoil.

Nearly one-third of Americans don’t have enough stashed in their emergency savings to cover a $400 emergency. In these situations, they tend to charge the expense to a credit card (usually with a high interest rate), borrow from friends or relatives, secure a payday loan, or tap into retirement savings in order to pay for the unplanned expense.

These options can all be more expensive than they initially appear. For payday loans or credit cards, the high interest rates mean that if they’re not paid off right away, they’ll accrue more debt for the borrower. And borrowing from retirement savings means undermining your own nest egg: Every time you deplete a 401(k) account, even by just a little bit, it will take exponentially longer to reach your retirement goals.

So it’s smart to have an emergency fund — one that you contribute to over time, just like a 401(k), but it should be easy for you to spend the money in your ESA. You’ll want to be able to withdraw or transfer your emergency fund without worrying about any penalties or fees.

Just knowing this money is available if you need it can provide peace-of-mind and lower your stress levels, but having an emergency fund can also provide a barrier against long-term debt and help you improve and maintain your financial health.

How a 401(k) and an ESA balance each other

Building both retirement savings through a 401(k) and emergency savings through an ESA are complementary activities that, when tackled in tandem, can significantly improve your financial outlook, especially over spans of years and even decades.

As a long-term account, your 401(k) is designed to accumulate wealth over time. Investing early and contributing often can ensure that you’ll have a comfortable amount of money saved up for retirement by the time that day arrives.

By contrast, an emergency fund is meant to be depleted. If you don’t encounter any emergencies and can continue to contribute to its growth, then that’s great! But if a sudden and unexpected financial need does happen to emerge, having an ESA can help ensure you don’t need to withdraw any money from your 401(k).

Where should you put your money today? Tomorrow?

These are personal questions that are going to depend on your age, how long you intend to continue working, your current and future projected cost of living, your household size, and many other factors. So while it’s true that everyone should have both retirement (long-term) and emergency (short-term) savings, the amount you save and the pace at which you save it are going to be different for everyone.

Generally speaking, you’ll want to start building both your ESA and your 401(k) as early in life as possible. Every six months, or at the very least every year, make a point to sit down and review your retirement and emergency fund allocations. Could you be saving more in one or both accounts? Are you taking full advantage of any matching or bonus contributions available to you?

In most cases, contributions and matches to a 401(k) are percentage-based, meaning you select a portion of your total compensation to contribute to the 401(k). If your employer offers a match, it’s smart to contribute the maximum amount toward the match. For example, if your employer offers to match 5% of your earnings toward 401(k) contributions, then you should contribute at least 5% so that you can take full advantage of the match.

Building an ESA usually involves selecting a certain dollar amount to contribute every month. If a workplace ESA offers a matching contribution, then it’s once again wisest to contribute the maximum amount. Let’s say your employer is willing to contribute $5 toward your workplace ESA if you contribute up to $20, and there are no additional contributions available above that $20 benchmark. In this case, contributing $20 every pay period to your ESA will capture that full $5 match and help you grow your savings faster.

The most effective and efficient way to save for both long-term and short-term goals is to automate contributions. If you’re automatically and seamlessly adding more money to your 401(k) and your ESA every pay period, they will quietly grow over time with no effort beyond setting up the initial automated deductions from your paycheck or your bank account.

The smartest way to manage a financial emergency

Financial emergencies can and do happen to anybody and everybody. Although it might be tempting to use long-term savings to solve a short-term problem, the best way to handle a financial emergency is to use cash or its equivalent, such as liquid funds stored in an ESA.

Leveraging a 401(k) to pay for an emergency — or adding a charge to a high-interest credit card, or taking out a payday loan — all have long-term financial consequences for borrowers. Taking money out of a 401(k) before retirement means paying fees and tax penalties as well as delaying your long-term retirement goals, possibly indefinitely. And the interest rates for credit cards and payday loans can take months, if not years, to pay off entirely.

The synergy between ESAs and 401(k)s

When built and managed appropriately, an ESA and a 401(k) exist in a kind of symbiotic relationship. Establishing an ESA helps protect the funds in a 401(k) and allows them to grow more effectively than they could otherwise. And the presence of a 401(k) means that the money in an ESA isn’t hoarded for some distant future goal but instead can be spent immediately when the need is there.

Contributing savings toward both an ESA and a 401(k) — especially when either or both accounts are workplace-sponsored — is one of the best ways to secure your financial future for whatever lies ahead.

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