Pricey Penny: Was it a mistake to make use of 100% of your financial savings to repay your debt?

Dear Penny,

I'm 28 and I've just paid off all of my debts. But after reading your column, I realized I had done something stupid.

I used all of my savings to pay the balance. Now all of my accounts – cash, emergency, long-term – are at zero. I have no debts, but no assets. I plan to save 20% of every paycheck per my budget. Am I in serious trouble or just a temporary bubble to work my way out of with a little self-discipline?


Dear J.,

I cannot guarantee you that tomorrow will not be a catastrophe. Maybe it's the day your car dies and your cat needs an emergency to the vet and you lose your job that same day. So yeah, if the world implodes tomorrow, you are in serious trouble. But if you stick to your plan and get through the next year or so without major disasters, I think you'll be fine.

Until you beat yourself up too badly, I don't think what you did is going to be stupid. My definition of stupidity would be to spend all of your savings on vacation or to buy a toy that you couldn't afford. You have spent the savings of your life paying off debts. You will be in a better position in the long run. But you are in a dicey position for the next several months.

Here's your plan of action: after you've paid off credit cards, leave the accounts open even after you've sworn off debt. You want this balance open for whatever worst-case scenario you encounter while rebuilding your savings. Also, it helps you keep old credit accounts open and use them occasionally to maintain good credit.

If your employer matches contributions to a 401 (k) or other retirement account, you'll be paying in just enough to get the match. In addition, every additional cent will flow into your savings account until you have built up three months of emergency savings. If you take your paycheck home with you, your 401 (k) contribution won't even take that 20% into account as the money will be withdrawn before you see it.

When you've built your three-month emergency fund, pat yourself on the back. But wait! You are not done yet. Your ultimate goal is to save for six months. But once you're worth three months, you have a little more wiggle room in terms of how to use that 20%. For example, you could put 10% of your savings every month, plus 10% into a Roth IRA.

Once you've searched retirement accounts to pay off your debts, you need to anticipate the tax implications. The IRS charges you a 10% penalty and treats early retirement distributions as taxable income, although you can access Roth contributions at any time without penalty. In fact, if you've made an early withdrawal, I would recommend focusing on your three-month emergency fund before budgeting for taxes. It's extremely easy to set up an IRS payment plan when you owe taxes.

There are no easy answers for dealing with emergencies before you have built up your savings. However, if you do need to use a credit card for an unexpected expense, I would recommend paying the minimum until you've been saving for three months.

They say you plan to save 20%. Is it possible to get just a little more out of this paycheck? The benefit is twofold: by forcing yourself to save more money, you are living on less and thus lowering the minimum required savings.

Let's say you make $ 3,000 a month after taxes. You live on 80% or $ 2,400 and save the remaining 20%. You need an emergency fund of $ 7,200. If you save $ 600 a month, it will take you 12 months to build one.

But let's say you can live on 75% and save the other 25%. All you have to do is cut off your budget by $ 150 per month. You would lower your minimum emergency fund requirement to $ 6,750. If you were saving $ 750 a month it would only take you nine months to get there. It can be more doable than you think since you are no longer paying debts.

If it is not possible to save more than 20% of your current salary, consider getting a part-time job. It doesn't have to be long term. If you pocket some extra cash for a few months, you can build up your savings again quickly. Anything you can do to cut the time without an emergency fund is a huge win.

There are few scenarios where your finances are truly doomed by the age of 28. If you can manage to live a lifetime of debt free (barring maybe a day's mortgage), stay on a budget, and save at least 20%, you are in tip-top shape.

Robin Hartill is a certified financial planner and senior writer at The Penny Hoarder. Send your tricky money questions to [email protected].

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