One of the first pieces of advice every personal finance guru will give you is “build up your emergency savings.”

The advice has become as ubiquitous as it is effective. An emergency savings account (usually set at 3-6 months of a person’s expenses) is an excellent first line of financial defense. Being able to cover a surprise car repair or a temporary jump in your regular expenses without turning to credit cards or temporary loans can save people huge amounts of money and keep their budgets on track. Without this cushion, people might be more prone to fall into a financial vortex—a situation where the expense of borrowing sends a person’s finances spiraling out of control.

To help people maintain this buffer, some employers have begun offering emergency savings accounts (ESA) as a benefit. An ESA is simply an easily accessible debit account that employees can use for emergency expenses. The accounts are funded through paycheck withholdings, with some employers even offering a contribution match until the account is funded.

The logic behind these accounts is simple: many employees want to have emergency savings but need a bit of help to make sure they stick to funding it.

However, ESAs are not the only worker benefit that’s increasing access to emergency funds. As part of the SECURE 2.0 Act, Congress sanctioned more types of emergency withdrawals from defined contribution plans. The new rules can reduce the penalty for those that need to access retirement funds in bad situations, including natural disasters, domestic abuse situations and generic emergency expenses.

While there are reporting requirements for emergency retirement withdrawals, it only takes the self-certification of the account holder to validate the need. The process will never be quite as frictionless as using a personal emergency savings fund, but it is an improvement for people in a difficult situation who have much more to worry about than filling out paperwork.

Does this access to retirement funds change the way employers and employees should think about emergency savings? Are designated emergency savings even necessary now? Can a retirement account be relied upon to save people from falling into a financial vortex?

Well, it’s complicated.

Let’s think about expenses, debt and the financial vortex.

There are definite “costs” to tapping a retirement account for emergencies: 1) the excise tax for early withdrawal, 2) loss of tax advantage savings and 3) loss of investment growth on those savings. In a general sense, using a retirement account for emergency savings only “works” if all the costs of withdrawing are less than all the costs of not withdrawing.

Although the SECURE 2.0 Act eliminated the first of these costs (i.e., the 10% excise tax) for more types of emergency withdrawals, the impact of the other two must be considered.

For instance, a person might think: “It’s better to take a $1,000 withdrawal from a retirement account than carry an extra $1,000 on a credit card with a 20% interest rate. In one year, I’ll spend over $200 just on interest and that will put more strain on my budget.”

However, this isn’t that simple.  Withdrawals of pre-tax retirement contributions still come with a tax liability if they are not repaid within a year. While a $1,000 withdrawal might spare you $200 in credit card interest, you may still find your budget wrestling with a $100–$200 expense come tax season.

On top of that, there’s the lost opportunity for growth. Assuming an average 6% growth, a $1,000 withdrawal will mean $60 of lost annual growth. If this were a standard investment account, it would be possible to make extra contributions to restore that lost value eventually, but since tax-advantaged accounts have annual contribution limits, this may not be possible if you regularly hit your contribution limit.

While none of these issues mean that emergency retirement withdrawals are bad in every situation, they do highlight how it’s not an obvious solution in most cases. A retirement withdrawal can save someone from falling into a financial vortex, but it shouldn’t ever be automatically treated as the first source of financial defense.

Congress’s goal with SECURE 2.0 was to provide options for relief. (That’s a good thing!) But just because the government has made it easier for retirement accounts to act as emergency savings, we can’t let ourselves begin to think of them as a substitute. People need to have a dedicated account for their emergency costs, and saving for retirement needs to be treated as a necessary expense.

How can employers get involved?

As mentioned earlier, some employers have tried to improve the financial resilience of employees by creating employee ESAs. Employees undoubtedly appreciate this option, but we should remember that ESA money is basically just normal income. An ESA isn’t like a 401(k) plan or health insurance that’s available through a group; any employee can start their own savings account at a bank—they just need to be encouraged to do it. This is a matter of financial education.

Additionally, the new emergency withdrawals under SECURE 2.0 are optional for plans to adopt. Plan sponsors don’t have to offer them if they think it will create problems. They can permit only normal early withdrawals and hope the 10% excise tax will discourage people from tapping into their retirement savings.

While continuing to penalize withdrawals might be done for participants’ own good, sponsors should remember that disasters do happen to people. If tapping a retirement account is a participant’s only option, the 10% excise penalty won’t stop them—it will only make the situation more painful.

Emergency savings are great, but the best solution is always going to be education. People need reminders and encouragement to save, awareness of how an emergency fund can protect them and clear examples of the true costs of early withdrawals from retirement accounts. The Foundation has a helpful Financial Education/Retirement Security Toolkit with additional resources for employers to help support employees through financial education.

Jonas Leyrer, CEBS

Favorite Foundation Product:  Financial Skills for Life: an online learning course that apprenticeship programs and companies can offer to their younger workers to ensure they have a foundational knowledge of personal finance and benefits.
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In his free time, Jonas enjoys playing board games, running and watching professional soccer matches.

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