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1 in 5 Americans with a retirement account tapped it during Covid — that's ringing 'alarm bells'

"A lot of my millennial clients now understand the concept of emergency funds."

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Twenty/20

The pandemic pushed a lot of workers to the brink — and some people who lost income during the pandemic had to take drastic measures to make ends meet, such as dipping into retirement accounts, according to a new survey from Bankrate.

The survey finds that 1 in 5 people with retirement accounts have taken early disbursements since March 2020. More than half, 51%, of those polled said they've taken at least one early withdrawal in their lifetimes.

Those statistics are ringing "alarm bells," says Greg McBride, chief financial analyst at Bankrate. "It speaks to how close to the edge many households are currently, in that they're having to tap their retirement accounts early for unplanned expenses."

The pandemic highlighted how important it is to have an emergency fund that can cover 3-to-6 months worth of living expenses. That was especially true for people under 40, says Tess Zigo, certified financial planner at Emerge Wealth Strategies in Chicago, Illinois.

"A lot of my millennial clients now understand the concept of emergency funds," Zigo says. "They're like, 'Oh, yeah, because we lived through Covid, now I understand why I need an emergency fund.'"

But knowing that you ought to have some cash stashed away for a crisis doesn't help when you need that money today, Zigo notes. "You have these fixed expenses, and then you lose your job. Now, you're stuck between a rock and hard place," she says.

When faced with those tough decisions over the past year and a half, some Americans turned to their retirement accounts to fill the gap.

Early disbursements are 'robbing Peter to pay Paul'

In addition to showing just how many Americans currently live close to the edge, Bankrate's findings are a warning sign that those who tapped retirement funds may be less financially prepared for their golden years, McBride says. "It's a one-way street," he points out. "People won't be adequately prepared for retirement later. The money you take out of the retirement account now to cover unplanned expenses is not [usually] money that goes back in at a later date."

Taking money out now decreases your principal, which means you'll be earning less from the compounding interest on that principal. But there are other concerns too.

If you take a disbursement from a traditional IRA or 401(k) before age 59½, you'll incur a 10% penalty and have to pay income taxes on that money. Early withdrawals from a Roth IRA can be less of a headache: If you withdraw from your principal in that account, you won't pay taxes or penalties, since that money was already taxed when you put it in.

Neither is a great option, McBride says. "You're literally robbing Peter to pay Paul, but you're Peter and you're Paul," he says. "Peter is your future self. Paul is your present self."

In a pinch, a Roth IRA can be 'another set of emergency savings'

Taking money from your retirement account to cover expenses is never ideal, experts say. But crises happen, and if you don't have an emergency fund, you'll need to make tough decisions.

As of July, less than 50% of Americans had enough savings to last them three months if they lost their income, according to Banrkate's annual emergency savings survey. A quarter, 25%, didn't have any savings for a rainy day at all.

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That number was even higher for millennials, 57% of whom had little or no emergency savings. For many, the pandemic imprinted why emergency funds are so important, Zigo says, and it highlights why Roth IRAs can be great investment accounts, especially for younger investors. You can withdraw your own contributions at any time — and provided you're 59½ and have held the account for at least five years, you can withdraw both your contributions and earnings tax-free.

In a pinch, the principal — the money you initially invested — can be withdrawn without much hassle. Remember, Roth IRAs should not be your only source of an emergency fund; the account is subject to market fluctuation.

"I love the Roth IRA for young people, because it's kind of another set of emergency savings," Zigo says. "You can use the money that you put in any time for anything. There's no taxes. You've already paid taxes on it, and there's no tax penalty. So it's a great way to supplement your emergency fund."

If you qualify, consider opening one "right when you graduate," she says. "I opened one when I was 20."

Start building a small, '2-week emergency fund'

While it's ideal to have an emergency fund and never have to tap your retirement accounts, that's easier said than done, says Peggy Doviak, a CFP and founder of DM Wealth Management in Norman, Oklahoma. "It's so overwhelming to try to save the money that they don't start because they think they can't do it," she says. "So why would you even try because you'll never be able to save six-months [worth] of your bills."

To jump that psychological hurdle, Doviak suggests starting very small. Instead of worrying about saving $300 a month, knock that goal down to a more "realistic" number, like $25 or $50.

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"Instead of focusing on the six-month goal, you could create a two-week emergency fund," Doviak says. "People think they should be putting back $300 a month, and, sometimes, if you're young, you don't have the money to do that."

Setting aside a smaller number makes it easier to get in the habit and stay consistent, Doviak says. "Then when you save your two weeks, take two more and celebrate every time you do it," she says.

For the price of "three coffees, you can save $25 a month," Doviak says. Those "itty bitty amounts" add up quickly. "Then if you need tires for your car, or you need a short-term amount, you've got it."

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