Emergency funds need a PR makeover. Who wants to think about broken-down cars, sick dogs, or job loss? We should call them “cushion funds.”
Then there’s the frequently cited ideal amount: three to six months of expenses. That’s a decent starting point, but it sounds off-putting to people just starting their financial journey.
In addition, people often assume that building a cash cushion means they’ll have to hold off on investing for the long term. But that’s not necessarily true: While it’s always valuable to have money in accounts that could be liquidated on a moment’s notice, a Roth IRA can serve as a good multitasker because those contributions can be withdrawn without penalty. And you’re still growing your retirement nest egg.
Whatever we call them, emergency funds are crucial at any life stage. They can: — Keep you from resorting to high-cost financing. — Help you defray unexpected expenses, like a new roof or healthcare costs. — Protect your retirement accounts. — Cover your basic costs in case of job loss. (That’s where the three to six months guideline comes from.)
Here are the key steps to take when setting up your emergency fund:
Step 1: Determine your monthly living expenses
Tally up your major essential monthly outlays: housing, utilities, food, debt, insurance, and taxes. Skip nonessentials like discretionary clothing, cable/streaming, etc. Multiply your essential expenses by three months. This is your absolute minimum savings target for your emergency fund.
Then customize for you. Contractors or others with irregular income should have bigger cash buffers. If you lose a specialized job with a high salary, another one could be harder to find.
Finally, how much flexibility do you have to cut expenses? New graduates who could readily relocate, get roommates, or move back in with mom and dad can get away with a smaller emergency fund. But if you have a mortgage, two car payments, plus children and related expenses, your emergency fund should be much larger.
Step 2: See how much you have right now
Add up your checking and savings accounts, money market accounts and funds, and certificate of deposit accounts. Exclude assets earmarked for other purposes, such as money you’re saving for a car down payment or college tuition; also exclude cash holdings in your stock or bond mutual funds. That total is your current emergency fund.
Step 3: Set your emergency-fund savings target
Subtract the figure in Step 2 from the figure in Step 1. This is the minimum you need to save. Hitting this target should be your main priority in the months ahead. (If you’re also paying off high-interest credit card debt, you should still try to build up your emergency fund at the same time.)
Step 4: Identify appropriate investments
Your emergency fund is not the spot to stretch for extra income, especially given how small the differential is between the Federal Deposit Insurance Corporation-insured cash instruments and riskier alternatives like bond funds right now. My advice is to use plain-vanilla cash investments: checking and savings accounts, CDs, and money market accounts. Online savings accounts are often one of the highest-yielding cash options; credit unions also frequently offer decent yields.
Note that some product types aren’t FDIC-insured; money market mutual funds, for example, do not qualify for FDIC protection, though, in practice, they’ve been quite safe. But money market accounts at banks are FDIC-insured. (You can compare yields on FDIC-insured products on Bankrate.com.) Remember that CDs carry penalties if you get your money out prematurely.
Step 5: Find the right receptacle
Finally, you want to be able to access these funds without taxes or penalties. For that reason, it’s best to maintain your cushion outside your retirement accounts.
Still, a Roth IRA can help back up your emergency fund. And those contributions (but not earnings) can be taken out at any time and for any reason. Setting one up is a great first step when you get started in investing.
If you’re a homeowner, you can get a home equity line of credit to use if your emergency fund runs out. HELOC interest rates are usually low and may be tax-deductible if the funds are used for certain home improvements. Set one up while you’re employed, because it’s much harder to get this type of financing if you’re not.
Benz writes for Morningstar. This article was provided to the Associated Press by Morningstar.
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