Dear Penny: Was Using 100% of My Savings to Pay Off Debt an Awful Mistake?

Dear J.,

I can’t guarantee you that tomorrow won’t spell disaster. Perhaps it’s the day your car dies and your cat needs an emergency trip to the vet and you lose your job all on the same day. So yes, if the world implodes tomorrow, you’ll be in serious trouble. But if you can stick with your plan and get through the next year or so with no major disasters, I think you’ll be fine.

Before you beat yourself up too badly, I don’t think what you did rises to the level of foolishness. My definition of foolishness would be spending all your savings to take a vacation or buy some toy you couldn’t afford. You spent your life’s savings to pay off debt. You’ll be in a better position long term for having done so. But you’ve put yourself in a dicey situation for the next few months.

Here’s your action plan: If you’ve paid off any credit cards, keep the accounts open even if you’ve sworn off debt. You want to have that credit open for any worst-case scenarios you encounter while you’re rebuilding your savings. Plus, keeping old credit accounts open and using them occasionally helps you keep a good credit score.

If your employer matches contributions to a 401(k) or another retirement account, contribute just enough to get the match. Beyond that, every extra cent goes into your savings account until you’ve built three months of emergency savings. If you’re budgeting your take-home paycheck, your 401(k) contribution won’t even factor into that 20% since the money is taken out before you see it.

Once you’ve built your three-month emergency fund, give yourself a pat on the back. But wait! You’re not done yet. Your ultimate goal is to build six months’ savings. But once you have three months’ worth, you have a bit more wiggle room as far as how you use that 20%. For example, you could put 10% toward your savings each month, plus 10% in a Roth IRA.

If you raided any retirement accounts to pay off your debt, you’ll need to budget for the tax consequences. The IRS charges you a 10% penalty and treats early retirement distributions as taxable income, though you can access Roth contributions any time without penalty. If you did make an early withdrawal, I’d actually recommend focusing on your three-month emergency fund before you budget for taxes. It’s extremely easy to set up an IRS payment plan when you owe taxes.

There are no easy answers for how to deal should you encounter an emergency before you’ve rebuilt your savings. But if you’d need to use a credit card for an unexpected expense, I’d recommend only paying the minimum until you’ve built three months’ savings.

You say you’re planning to save 20%. Is it possible to squeeze just a little more out of that paycheck? The benefit is twofold: By forcing yourself to save more money, you make yourself live on less, thereby lowering the minimum you need to have in savings.

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

But suppose you can live on 75% and save the other 25%. You’d only need to trim $150 a month from your budget. You’d lower your minimum emergency fund needs to $6,750. Saving $750 a month, it would take you just nine months to get there. It may be more doable than you think since you’re no longer making debt payments.

If saving more than 20% of your current salary isn’t possible, consider taking on a side hustle. It doesn’t need to be long term. Just pocketing some extra cash for a few months can help you rebuild your savings quickly. Anything you can do to shorten the amount of time you’re without an emergency fund is a big win.

There are few scenarios where your finances are truly doomed at 28. If you can make lifelong habits of living debt-free (aside from perhaps a mortgage someday), sticking to a budget and saving at least 20%, you’ll be in shipshape.

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