I am an advocate of paying down or paying off a home mortgage when the situation fits right. When it comes to contributing to a 401k plan, my feelings are somewhat mixed, although I generally find it makes sense to get an employer match.

The biggest problem with putting extra money into paying down a mortgage or contributing to a 401k plan is the same.  The problem is that you are locking up your money.  It becomes illiquid.

In the case of a mortgage, you can’t get back that extra you pay on the principal amount unless you refinance or sell your house.  If you pay off the mortgage in its entirety, then you get the benefit of the additional cash flow each month.

In the case of a 401k plan, you will likely be restricted from withdrawing “your” money if you still work for the employer that sponsors it.  You may be able to take a loan, but then that will hurt your future cash flow, as you have to start paying off the loan almost right away.

Even if you no longer work for the employer that sponsored your 401k plan, you will still get hit with regular income taxes (assuming it’s not a Roth 401k), and you will pay an early withdrawal penalty if you are younger than the designated retirement age of 59 and a half.

Therefore, if someone is considering paying down their mortgage or contributing extra to a retirement plan, I recommend that this only be done if a liquid emergency fund is already set up.  While personal situations call for different actions, I generally think a 9-month emergency fund is appropriate, although a year might be better.  This would be based on 9 months of living expenses, not 9 months of salary.

In the case of a mortgage, you can take into consideration whether you are actually able to pay off your mortgage.  If you can pay off your entire mortgage, but it will leave you with only 4 months of living expense, it may be worth doing anyway.  Your monthly expenses will go down by the amount of your mortgage (not including any taxes or insurance that is rolled in). Your monthly cash flow should increase substantially, and you should be able to build up your emergency fund quickly with the additional savings each month.

Liquidity is the Key

When setting up an emergency fund, liquidity is the most important factor.  If you lose your job or you have a major emergency expense, then you have to be able to access your money quickly.  If most of your money is tied up in your house, then this is not liquid.  It takes time to sell a house.  It even takes time to refinance, and this could be costly with closing costs.

When it comes to accessing emergency money, you typically need to be able to access it within a month.  There may be scenarios where you need to access money almost immediately.  But in today’s world with credit cards, you can usually push things off for a month without hurting yourself much.

Most people think of an emergency fund as a savings account or money market fund.  These are obviously appropriate vehicles. The problem is that they pay almost nothing in terms of interest.

I think it is good to have some extra money in your checking or savings account for emergencies. At the same time, I don’t think it is necessary to have 9 months of living expenses sitting in your bank account.

You can still have liquidity without having total safety.  If you have a non-retirement brokerage account, it is generally liquid.  You can access the money reasonably quickly.  The only risk is if you are investing in stocks or other investment vehicles that could lose significant value.  Therefore, you have to adjust based on the riskiness of your investments.

If you are invested heavily in stocks, then you may want to double the amount in that account that you would actually need for an emergency.  You should assume that you could lose half of your money with a market downturn.

If there were a major market downturn and you had to access your money, this would be painful because you would be selling securities that are down in value.  You would have bought high, and you would be selling low.  This is a bad investment formula.  Therefore, this “emergency money” should only be for really dire circumstances.  You shouldn’t be selling stocks when they are low in order to fund a broken water heater or to pay for Christmas gifts.

I am an advocate of the permanent portfolio as designed by Harry Browne.  It is far from being perfectly safe, as is the same with every other investment.  Even money in a bank has risk, especially when it comes to inflation.

The permanent portfolio will generally avoid major swings.  It is well diversified, which smoothes out the ride.  You won’t get the wild ups and downs as you would investing in one sector or one investment type.  Therefore, I think it is reasonable to have part of an emergency fund in the permanent portfolio if it is outside of a retirement account.

In addition, consider that you can invest in a Roth IRA, which is a way to allow your investments to grow tax free (assuming the government doesn’t change the rules). You have already paid taxes on your earnings that are invested in a Roth IRA, but you will not pay taxes on the compounding gains.  This is especially helpful if you have a large degree of uncertainty of tax rates in the future.  You lock in the certainty of paying the tax rates of today.

I think it is typically better to leave your Roth IRA alone in terms of not withdrawing money from it early.  You can add to it, and you can rebalance your portfolio as necessary, but you don’t really want to withdraw money before the designated retirement age if you can help it.

With that said, I still think you can account for a portion of your emergency fund with a Roth IRA (not a Roth 401k).  You can withdraw your money at any time.  And if you only withdraw the principal amount that you have contributed, then you will not pay any additional taxes or penalties.  You would only potentially owe a penalty if you withdraw capital gains within 5 years.

Therefore, if you have a 6-month emergency fund in your bank account and a sizeable amount in a Roth IRA invested in something relatively stable like the permanent portfolio, then I think this is appropriate for the needs of most people.  You would want to touch your Roth IRA last in most situations, but at least you know it is there when you need it, and you won’t be penalized for accessing your money.