It was one of the most-reported financial changes due to the CARES Act passed by Congress in response to the pandemic: savers can take funds out of their 401(K) plans without paying the 10% penalty, and have three years to pay the funds back entirely without having to pay taxes on them.
This might seem like a huge boon that is worth repeating every crisis. After all, a once-in-a-century opportunity to avoid the 10% penalty on early withdrawals? Tax-free IRA withdrawals? Especially given the financial hardship many are going through during the pandemic and subsequent economic lockdowns, it may be tempting to raid your retirement fund for the emergency and then worry about saving again later.
Not so fast.
Certainly, for those who have no alternative and need funds to survive, not even the usual 10% penalty would stand in the way of that.
But for those being tempted by the opportunities of a potential tax-free, penalty-free withdrawal, it is important to keep in mind the key reasons why a retirement fund is not the same as an emergency fund.
First, there are the tax caveats: nothing is ever as simple as it seems. Yes, there are no long-term income taxes to be paid on the withdrawals taken from your retirement account in 2020…if you pay back the whole thing in 3 years…and only after you have already paid the taxes on the withdrawal. In other words, the IRS still wants your taxes on the withdrawal, but they will refund those taxes to you if you file an amended return after you have paid back the entire withdrawal.
So the tax-free, penalty-free process really goes something like this: withdraw the funds, pay the taxes, pay back the funds, file an amended return, get a tax refund.
Not so simple as it first sounds.
What if you don’t end up returning the money? Well, then, the best you can hope for is to spread the tax implication of those funds over the next 3 years.
The second reason goes to the heart of the difference between a retirement fund and an emergency fund. As any financial planner can tell you, an emergency fund is a fund of liquid assets that you can tap into in an emergency, and the fund should be able to last between 3 to 6 months depending on factors such as if you are married or have kids.
A liquid asset is something you can get at extremely quickly. You don’t have to worry about selling it or finding a buyer. On the flip side, for example, a piece of real estate is not a very liquid asset: it takes time to sell it for cash. Examples of liquid assets are your checking account, or a money market fund.
What do checking accounts and money market funds have in common? Well, they are liquid and they are very close to risk-free assets, meaning you don’t worry that they will suddenly decline in value. But like many risk-free assets, they don’t grow much. They don’t increase in value over time.
And that’s okay. Because an emergency fund is not there to increase in value over time. It’s there to last those 3 to 6 months in an emergency.
A retirement fund, on the other hand, is meant to grow. It is meant to take advantage of the power of compound interest so that the $5,000 per year you are saving in your IRA or Roth IRA every year will, over 10 or 20 or 40 years, be worth much more than the sum of the savings.
Let’s look at a simple example.
Imagine that you contribute $5000 at the end of every year to a retirement account for 10 years, and then do not save again for the rest of your life until you retire 40 years later. Let’s also assume these retirement savings grow at a modest annual rate of 5% over those 40 years. At the end of those 40 years, you will have approx. $307,000 in savings.
That $307,000 is far more than the dollar amount you actually saved over those first 10 years: $50,000. That difference is the result of 40 years’ worth of compound interest at 5%.
Now let’s imagine that, in Year 11, crisis strikes, and you take $70,000 out of your retirement fund. There is no penalty, no taxes, nothing. After three years (at the end of Year 14), your situation has improved, you put back the entire $70,000, and it starts growing again.
How much will you have after the 40 years? Approximately $267,800.
That tax-free, penalty-free withdrawal of $70,000 that you put back in its entirely 3 years later would cost you about $39,000 out of your future retirement amount, or a 12.8% decrease from what you might have had otherwise.
That tax-free, penalty-free withdrawal proved to be not so free, after all!
That’s because those three years missed out on 5% returns, and all subsequent years missed out on the 5% return on those 5% gains. Compound interest leaves a big hole when you’re not earning it.
And that is the key. Saving for retirement isn’t just about the cash you save today. It’s about the value of that cash when you do retire in the future, and the power of compound interest to make your savings worth more in the future than they are now.
Treating a retirement fund like an emergency fund means foregoing not just the savings of today, but the future earnings of tomorrow.
Both retirement funds and emergency funds are key components of any financial plan. They complement one another, and a financial planner like those at Emergent can help you create and manage both. But as with any pair of complementary goods, that means they are not interchangeable. Each has a role to play, and it is important to recognize those different roles. Doing so may help us avoid the costly financial errors of decisions that appear to be “free.”
Alex Urpí, CFA®