Life can be full of surprises — and some of them can be costly. A car repair, busted HVAC system or medical bill could leave you reaching for a credit card and racking up costly interest payments if you don’t have savings to bail you out. A layoff could similarly leave you taking on debt or raiding retirement funds if you don’t have cash reserves available.
That’s why an emergency fund is crucial. In the past, many financial experts would advise having enough cash to cover three to six months of essential expenses to get through a period of unemployment. Given today’s challenging labor market, it may be a better idea to maintain a 12-month emergency fund, just in case.
Rising long-term unemployment
In September, the share of unemployed workers who were jobless for 27 weeks or longer reached 27.1 percent. One year prior, it was 23.6 percent.
“The old rule of thumb was to have enough [money] set aside to cover three to six months of expenses. But I think a year’s worth of cushion is a better goal today, especially given the job market and rising costs,” said Mary Ware, managing partner and senior wealth adviser at Carnegie Private Wealth in Charlotte.
Seasoned professionals need more cash
Trevor Houston, financial adviser and CEO at ClearPath Wealth Strategies in Frisco, Texas, said a 12-month emergency fund is not a universal requirement.
“Three to six months may be enough for someone earning $50,000 a year in a high-demand profession, but that doesn’t mean it’s enough for everyone,” he said. “For a 55-year-old executive who has spent nearly 20 years building a career in one industry and earns $200,000 a year, it’s highly unlikely they’ll find a comparable job within three to six months.”
Houston said he routinely sees professionals underestimating the amount of time it might take to replace their income after a layoff. When that happens, he said, “They may make harmful financial decisions, like dipping into retirement savings, selling investments at the wrong time, taking on high-interest debt or accepting jobs that aren’t right for them just to make ends meet.”
A more robust emergency fund could turn an extended layoff into a temporary setback rather than a source of long-term financial damage. If the idea of accumulating 12 months of living costs is daunting, do it gradually. Automate small transfers to savings each time you get paid to eventually meet your goal.
And keep in mind that your emergency fund doesn’t have to cover 12 months of total expenses. If you’re out of work for an extended period of time, you can cancel your cable subscription temporarily and reduce spending in nonessential categories such as restaurant meals or event tickets. The key is to make sure your essential bills like mortgage or rent payments, utilities and groceries are covered while you’re not earning a paycheck.
Don’t expect strong returns
Accumulating a year’s worth of expenses is a big feat. Eager as you may be to invest your emergency fund and generate strong returns on your cash, it’s important to keep that money out of the stock market so you don’t have to worry about accessing it at an inopportune time. Selling off that sort of investment quickly could lock in losses.
“An emergency fund isn’t designed to make you rich. It’s designed to provide protection against the unexpected,” Houston said.
It’s generally best to keep your emergency fund in a high-yield savings or money market account, Ware said, since “You don’t want to have to sell investments in a down market to pay for a new roof.”
Houston said Treasury bills with shorter maturities may also be appropriate. You could also consider a CD ladder, which might allow you to earn a slightly higher interest rate than a high-yield savings account. Even if you’re forced to cash out a CD before maturity, the penalties are often minor.
Avoid too much emergency savings
Even with high-yield savings account rates being generous today, the potential returns from a stock portfolio could well outpace the interest on a savings account. For this reason, you don’t want to overfund your emergency savings. And going above the 12-month mark may be overdoing it.
“If you have more than a year’s worth of expenses in liquid accounts, consider moving some of that money into a diversified taxable brokerage account for medium-term needs, depending on when you’ll need it and your comfort with risk,” Ware said.
Houston said your goal should not be to have the biggest emergency fund possible. Rather, he said, ask yourself, “How long could I maintain my standard of living without jeopardizing my financial future if I lost my source of income tomorrow?”
The answer to that question could help you determine how much emergency savings to aim for, based on your specific circumstances.
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