Your Emergency Fund: Why, How Much, and Where?
Adequate emergency funds are essential to your personal financial success. This article talks about why you need to have an emergency fund and how to go about creating one.
Why Save for Emergencies?
There are many situations in life that you simply do not have control over. Because, many of these require immediate cash flow, it is essential to have emergency savings to cover them. If you have a personal investing account or retirement account you could pull funds from these, but for a number of reasons (including bad market timing, early withdrawal penalties, or a delay in the liquidity of actually selling your investment and receiving your funds), this is the last thing you want to do.
Financial emergencies can come in many forms: a job loss, significant medical expenses, home or auto repairs or something you’ve never dreamed of. The last thing you want to do is be forced to rely on credit cards or a loan which could simply compound the problem.
Having money set aside for emergencies not only prevents this from happening, but also gives you the peace of mind that comes from knowing that if something unfortunate was to happen that you will have a financial cushion to ride it out.
I’m sure that you have needed fast cash for a number of situations in your life, or seen situations where others have. Insurance may cover many of these scenarios for you, but there is always a chance that it won’t cover fully what you will need. Here are a few examples:
lost job or layoff
began a new job that required you to expense a geographic move
auto accident, auto retirement, or major repair
major home expense such as a broken water line, tree falling on your roof, fire, natural disaster effects, etc.
pet health care
unexpected taxes owed to IRS
death in family that required you to help pay for funeral and other expenses
unexpected medical expenses not fully covered by insurance
How Much do you Need in Emergency Savings?
For most people, I recommend that you keep emergency funds in two different accounts:
The first, which would be equal to 10% of your annual income, is kept in an account where you can get to the money within days and there would be no penalty for accessing it.
The second emergency fund is equal to 20% of you annual income, and should be kept in a tax-deferred account such as an IRA, 401k, etc. The reason that you can keep this emergency fund in tax-advantaged accounts is that, if you are doing good financial planning, you are highly unlikely to need it and if you do need it, it is most likely that it will be because you have lost your job. In that case, your income will be lower and you will probably be in a lower tax bracket. In that case, the penalties you have to pay to get access to that money will be less than the taxes you saved when you put it into that account.
If you are anticipating a major life changing event, increase your emergency fund or start another savings account. You do not want to be pulling from emergency funds to pay off anticipated expenses.
Where Should you Put your Emergency Savings?
For your first emergency fund (10% of annual income), you should be earning interest from your emergency funds, otherwise, you are losing value due to the effects of inflation. Place your emergency fund in a high interest savings account, checking account, or money market account (MMA). Stay away from certificates of deposit because if you pull your money out prior to the CD expiring, you will lose interest in the form of a penalty.
Go with a bank that offers quick and easy access to your fund and a competitive rate. Bankrate has a good rate comparison list. Use this as a starting point to see what the current going rate is before committing. Check back periodically to see if you’re getting the best going rate. If you’re not, don’t be afraid to switch. If you haven’t already, start building your emergency savings. It will help you sleep better at night.
It is important to keep this emergency fund in a place that will fairly liquid so that you can get to the money quickly in the event of an emergency. You also don’t want to have this money tied into stocks or mutual funds because the volatility of the market could cause you to lose money over the short-term.
The second level emergency fund (20% of annual income) should be invested in interest-earning accounts. Many 401k plans offer “Stable Value” Funds, which re an excellent option for your emergency funds. Start Small
If you currently don’t have an emergency fund or find it difficult to save money the key is to start small. You have to realize that accumulating one month’s worth of expenses will take some time, let alone three to six months. If you set your immediate goals to be small and manageable you will have a better chance in reaching them.
The best way to get started would probably be through your bank. Open up a new savings account if you currently don’t have one and begin to save with this first. The next step is to get into the habit of making regular deposits into this account. Whether it is weekly, bi-weekly or monthly, create a schedule and stick to it. Once you make savings automatic you won’t even have to think about it.
If you feel it is difficult to begin saving simply start with a small amount. Maybe you begin with $10 a week initially. While this won’t amount add up all that quickly the important thing is to start putting something away and to make it a habit. After a few weeks you won’t even notice that $10 missing so you can bump it up to $15 or $20 after a month or so. You will begin to get used to that money not being there and can slightly increase it again.