Tips for Building Your Emergency Fund
The importance of an emergency fund. Without an adequate emergency fund, you might be forced to take on high-interest debt, sell investments in a down market, or pay taxes and penalties on an early retirement fund distribution. An emergency fund allows you to not only play defense, but it can be a helpful tool in taking calculated risks that can help you achieve your goals. With an emergency fund in place, you’re in a more comfortable position to follow your passion and start a business, or move across the country to take on a job that’s a better fit. Our experience has been those that maximize their long-term strategic opportunities create the most wealth over time, and an emergency fund plays a huge role in this.
Understanding the opportunity cost of an emergency fund. The flip side of an emergency fund is the opportunity cost of holding such a large balance on your money in low yielding investments. While bank checking and savings account rates are trending higher, for every dollar sitting in an emergency fund earning 1%, that’s a dollar that’s not earning a market return with a long-term expected return of 6% to 8%, and that differential can really add up over time. The emergency likely won't even outpace inflation, so it's essentially losing money. As well, if you're prioritizing contributing to your emergency fund over tax advantaged accounts like an IRA or 401(k), you'll be missing out on the opportunity cost tax savings.
Moreover, bank interest is taxed at ordinary income rates, which can be higher than the capital gains rates you’ll earn in the stock market. The more you hold in cash, the math becomes incrementally harder to achieve your goals. For example, it would take saving $2,000 a month for a 32-year-old to sustain a lifestyle of $100,000 of annual expenses in retirement with a cash cushion of $100,000, but she would only need to save $1,500 a month with a cash cushion of $20,000, assuming 3% inflation. An emergency fund is basically a type of insurance, and you should find a balance between minimizing the opportunity cost of the emergency fund and maximizing your protection in case of an emergency.
Determining the right amount for your emergency fund. A rule of thumb that gets thrown around by many financial planners is to have an emergency fund in cash of two to six months of expenses, but there's no one-size-fits-all rule when it comes to emergency funds. Either way, you'll need to understand your expenses are and pull together a budget. The size of your emergency fund is highly dependent on how variable your income is and how marketable your skills are in the open job market. A real estate broker that does several transactions a year might want to have four or five months in his or her emergency fund given how his or her income can be so variable and how dependent it is on the strength of the economy. On the other hand, a partner at a large New York City law firm with steadier, predictable income or a UX designer with many inbound job offers might be able to get away with two months worth of savings. It’s best to do some thinking around different scenarios: how much cash would I need if I were out of work for three months? Six months? What if my spouse lost his or her job?
Customizing your emergency fund. It’s also important to consider your personal circumstances when thinking through an emergency fund. The more responsibilities and dependents you have, the higher the consequences of a change in your circumstances. A two-income family with no kids and no mortgage might only need two months cushion, while they would need a larger amount once they had kids and one of the parents left the workforce. Families with siblings, parents, or grandparents that lean on them financially from time to time might also have to think about a larger emergency fund.
Building your emergency fund in stages. It may make sense for most people to build their emergency fund in stages, so that you can make progress in various financial planning areas. For example, as you build from no emergency fund to an emergency fund covering 1 month of expenses, you might want to then prioritize paying off debt above a certain percentage level such as 8%. Once all your debt is below 8%, then perhaps you refocus on building two months of expenses. Once two months of expenses are covered, then you might want to prioritize maximizing contributing to your company’s 401(k) up to the employer match amount, and then go back to paying off debt above 5%.
Where should the emergency fund be? While the ideal place to park your emergency funds will change over time depending on market conditions, the usual suspects are bank savings accounts, bank checking accounts, very short-term CDs, US Treasury Bills, and money market funds. The important thing is that you have easy access to the funds, that the funds earn interest, and that the funds are invested in non-risky vehicles.
Considering when you don't need an emergency fund. At some point, you may not need much of an emergency fund. For example, if you’ve already reached financial freedom with a large investment portfolio over 20 times your expenses, a home with no mortgage, and several sources of steady income, there isn’t much need for an emergency fund since you could always use a home equity line or sell a portion of your portfolio. If you’ve done your financial planning correctly for a long period of time, you can self-insure against an emergency at some point. As well, it’s best to be practical and not too dogmatic about your emergency fund. For example, it’s rarely a bad idea to raid the emergency fund to make a modest contribution to a tax-advantaged Roth IRA, especially since distributions from Roth IRAs after five years are without penalty.
A small emergency is better than nothing. A Pew study indicated that 60% of American experienced a financial shock in the last 12 months, but median cost of the most expensive financial shocks was $2,000. So while we recommend that you save 2 to 5 months of expenses in an emergency fund, even much smaller amounts can go a long way towards preventing financial disaster.
If done right, emergency funds can help you sleep more soundly at night knowing that you’ll be alright if there an unfortunate turn in your life. With one in place, you’ll more confidently make progress on your goals like saving for retirement, buying a home, and saving for your children’s college education.
David Wilson, CFP®, CFA, CDFA®, CCFC is a New York City-based CERTIFIED FINANCIAL PLANNER™ Practitioner & Senior Wealth Advisor at Watts Capital. He can be reached at firstname.lastname@example.org.