3 reasons why you shouldn't use your 401(k) as your emergency fund

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Financial emergencies are bound to happen.Your car suddenly decides to stop running and need a new alternator. You're called into your boss's office one day only to be told that they are closing down your department and as of Friday and you no longer have a job. You have a relative who is sick, and you need to buy an emergency plane ticket to go and visit them.Whatever the reason might be, every financial emergency requires one key element - that you have cash in an emergency fund to cover the expense.

Emergency fund 101

As a refresher, your goal should be to save somewhere between three to six months’ worth of expenses in an emergency fund. If you’re an entrepreneur or run your own business, you might want to increase your emergency fund to cover six to twelve months of expenses to account for added expenses and inconsistent income.Your emergency fund should be separate from your main savings account because it's far too easy to dip into that account and be left without any savings if it's within easy reach. Two great places to consider for your emergency fund savings are Ally Bank and Synchrony, both which offer competitive interest rates, well above what traditional banks are paying.What happens if don't have an emergency fund, and there's an emergency?

The two most likely places to turn to are your credit cards and your 401(k). While they both aren't stellar choices, tapping your 401(k) for your emergency fund can have long-lasting and expensive consequences that can dramatically alter your financial future. It's not one of the smart money moves you should make this year.

All about the taxes

Tapping your 401(k) for any funds, let alone your emergency funds, comes with steep penalties. 401(k)s were created to be a giant piggy bank where you could stash away tax-deferred funds for your retirement. You put money in, it grows, and then when you retire you can take money out of your 401(k) as you need. There are countless ways to supercharge your 401(k) savings - and taking funds out for emergencies is certainly not on the list.When you take money out of your 401(k) before 59½, you are hit with a massive 10% penalty on the money you withdraw plus you have to count the money as income. While this might not seem like a big deal, let’s look at an example.You need $20,000 in emergency funds, and you take it from your 401(k). You're 35 years old, so automatically you've got a $2,000 penalty (10% of the amount you withdrew). On top of that, before you withdrew the funds you were in the 25% tax bracket, but now adding an extra $20,000 to your income for the year has pushed you into the 28% tax bracket, meaning you’re also going to owe more money on your tax return.

As you can see, this is already looking like a no-win situation. It's important to think about taxes and penalties before you tap your 401(k) because you can't simply just say, "Oops, I made a mistake. I didn't want to take that money; you can have it back."

Pay me back

As if penalties and taxes weren't enough, when you withdraw money from your 401(k) you likely will incur an interest penalty within your 401(k). Each employer has a different set of guidelines when it comes to borrowing or withdrawing money from your 401(k), so make sure you check with your HR department first. However, most companies impose an interest rate charge on any money that you withdraw until the day you pay it back. 401(k) plan administrators are required to set an interest rate that is "reasonable" - which is usually 1-2% above the prime rate.If we take it a step further, should you leave that company and you haven't paid your funds back, you will be in for quite a surprise. Many companies require that you pay back the entire loan (or amount you withdrew) within 30 days after you leave the company.Can you imagine having to find $20,000 if you didn’t already have an emergency fund set up?

The power of compounding interest

It’s rumored that Albert Einstein lovingly called the power of compounding the eighth great wonder of the world, and for good reason. Compounding interest is interest growing on top of interest. It's how you can contribute $10,000 to your 401(k) each year for 30 years, and magically it turns into hundreds of thousands if not millions of dollars. It's one of the top reasons why people use 401(k), IRA, and Roth accounts to save for retirement.If you had a 401(k) balance of $50,000 and let it ride for 30 years earning simple interest (simple interest pays the same amount of interest each year) at 6%, you would have $140,000. Simple interest, thankfully, is not how your money grows in your 401(k).If you had the same 401(k) with $50,000 and let it ride for 30 years earning 6% interest with compounding interest, you would have $287,174.56. That’s more than double the amount of money you would have using simple interest - see how powerful compounding is?

When you take money out of your 401(k), you are reducing the power of compounding. Taking our example above, what if instead of $50,000, you had $75,000 in your 401(k) because you didn't need to tap it for your emergency funds? In 30 years earning 6% you'd have a whopping $430,761.81.Compounding works best when you continually stack money on top of money and let it ride for an extended period of time. That's why if you're young(ish), you shouldn't worry about the stock market fluctuations: you have plenty of time for your 401(k) balance to rebound and continue compounding.If your company offers a matching funds provision, that’s another reason for you to just say no to tapping your 401(k) account. Matching funds are essentially free money that your company offers you as an incentive to stay working for them: if you contribute to your 401(k), your employer will match it up to a certain percentage, potentially doubling your contribution. The average employer match is 4.5%, but you should check with your HR department to find out what your company offers.A strong emergency fund is the best place to turn when life gives you lemons, so do whatever you can to begin building one today. If you do have to use your 401(k) for your emergency fund, make sure you understand the consequences and create a solid plan in your budget to repay those funds as soon as possible. You have a long future ahead of you and it’s key that you keep your money growing to fund all those amazing places you want to see and things you want to check off your to do list.

Image: Eelke