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“Life is just a bowl of cherries * but every once in awhile we get the pits.” *Lyrics by Lew Brown
Emergencies happen. They can put a serious dent in our budget and our lives. My parents kept money in envelopes around the house, under mattresses, and in cookie jars. That works for some of us. Having your savings in a bank generating interest income even at low rates is preferable.
You need to have an emergency fund as a financial safety net for unexpected expenses that are necessary and urgent. How large it depends on your basic living expenses and lifestyle. Establish your emergency fund gradually to cover your family’s basic needs for six months to a year. Many people have been out of work for virtually a year due to the pandemic making us realize how important it is to prepare for emergencies.
Expect The Unexpected
Our family recently went through a recent emergency in our house during the cold winter. Our water just stopped flowing..no sinks, no toilets! We had heat, which runs on a different system. We checked to make sure our circuit breakers hadn’t tripped. Our pipes appeared not to be frozen. We had no leaks anywhere.
Our plumber came over quickly. He went to the pump and tank in our basement. He tapped the control box and water to flow correctly. Lo and behold, our plumber declared our 40 plus-year-old tank and pump had lived its life to its fullest. We “mourned” its passing as it will cost $1,200 for the equipment’s replacement. However, we are celebrating the avoidance of potentially significantly higher expense (in the tens of thousands) if it had been frozen and burst with water damage.
I was thankful that we were able to have our plumber come over quickly. Having an ample emergency fund in place to fix this annoying event is a reminder for all of us. Yet, only 40% of Americans have $1,000 emergency savings on hand, according to a Bankrate survey. Protect yourself from having a cash squeeze or toilets not properly flushing.
Focus On Savings, Not Excuses
Yet, we all have excuses as to why we don’t need to set up an emergency fund account. You believe you have a stable job, your parents will help you out, or you can always use your credit cards. You may not be able to fathom putting one month of savings, let alone the recommended six months of money, in an emergency fund. It could simply be that you are procrastinating and intend to have one.
Unfortunately, you can’t time your financing needs for the unexpected times you need cash. As I indicated from our recent experience, you never know when equipment fails.
Make Savings A Habit
Start saving a little at a time if you don’t yet have it. Saving is a good financial habit. You should budget for 10% of your income going into savings. Part of those dollars should go towards unexpected needs. Here are some ways to save, ” 25 Ways To Save Money And Feel Good About It.”
Plan your emergency fund for six months or more as your goal. Your fund should be a big enough cushion to pay your monthly bills and costs such as food, rent or mortgage, utility, health care, car, property taxes, and pet care.
According to the 2018 Report of Economic Well-being of US Households, 40% of adults, if faced with unexpected expenses of $400, would either not be able to cover it or would do so by selling something or by borrowing. Data from GoBankingRates.com says 62% of Americans have less than $1,000 in savings.
Your Emergency Fund Is A Priority
The dollar amount you should have in the emergency fund account varies by a few factors:
The larger your family is in terms of dependents, including aging parents, the more money you should have on hand. You will need an ample cash amount when dealing with young children and the elderly which may be subject to more unknown medical circumstances than a young couple.
The more predictable your income is, the less you may need. Regular income is in contrast to generating less predictable income. About 30% of Americans have income that occasionally varies or quite often.
The younger you are, it is generally easier and quicker to find a job. A job search varies from 4-6 weeks if you are young to 55 weeks if you are 55+ years.
Your fund should be readily accessible and liquid. Later on, we will talk about how to invest this money.
10 Reasons Why You Need An Emergency Fund
1. Certain Events May Result In Higher Costs Are:
- Dental bills for root canal surgery;
- Emergency pet care;
- Home repairs like your roof from a sudden storm;
- Car repairs after running into a deer;
- Emergency room visits;
- Significant health expense for surgery, and
- Job loss.
We have experienced all of these unforeseen events; sometimes, two of these happened simultaneously. It can happen to anyone. Without readily available liquidity, it can be costly to pay for it through other means like borrowing.
2. Avoid Adding Debt
When faced with unexpected expenses, tapping your emergency fund is much more cost-efficient. Personal loans can get expensive unless you have a 700+ credit score. If you regularly pay your monthly credit card balance in full, then putting unforeseen expenses on your card may make sense.
However, if you have a less than stellar credit score, say in the 600 or below level, you may face mid-teens or high rates on a personal loan. Similarly, adding more debt to your card balances can be moving you in an inferior direction.
3. Insurance Doesn’t Cover Everything
For some unexpected events, you may assume insurance will cover those costs, such as medical expenses. However, insurance may not cover your whole bill, and there may be a deductible amount you have to pay. Insurance is always great to have, but you may be surprised about the additional expenses you may incur.
4. You Don’t Want To Sell Something You Want
Even if you are someone with many assets, like investment and retirement accounts, land, jewelry, art, and antiques, you may think you don’t need to have a separate cash account.
I can attest to the need for a separate fund from your investment accounts. The last thing you want to do is sell your stock investments in a volatile market to pay needed bills that you didn’t plan.
Other assets, especially those of sentimental value, may be even less liquid. Selling those items are usually not quick or easy when you need funds in a hurry. Bargaining power goes to the buyers in those situations.
5. Avoid Withdrawing Money From 529 Savings And Retirement Accounts
Don’t be tempted to use savings for college tuition and retirement for your emergency. These accounts are for specific purposes and beneficial for their compounding growth and tax-deferred nature. You don’t want to reduce your savings here, mostly when you may incur penalties and have to pay taxes on the amount withdrawn.
In the case of traditional IRA and 401K accounts, you may incur a 10% withdrawal penalty unless you are 59.5 years or meet IRS exceptions. The amount you took out is taxable income subject to an ordinary tax rate. There is a 10% withdrawal penalty if you are using the funds for non-qualified education expenses.
Related Post: Saving For Retirement In Your 20s
6. Borrowing From Your 401K Retirement Account Should Be The Last Resort
If you don’t have an emergency fund, you may consider borrowing against your employer-sponsored 401K account. Most employers do allow this. However, it is complicated to borrow from your 401K account and be a last resort to pay for emergency costs. You may want to consult a financial advisor.
Related Post: How To Choose A Financial Advisor
Generally, you are not allowed to borrow against an IRA account, either Roth or traditional. If you have an employer-sponsored 401 K retirement plan, your company may allow you to borrow from your own account.
There Are Downsides To Understand
You still lose the benefit of tax-deferred growth on earnings and potential employer matches during the time of repayment. There are borrowing costs, fees, and possible tax implications.
It is still preferable to have an emergency fund than borrowing from your retirement account. Remember that these savings you are investing are for your nest egg benefiting from compound growth. Removing these dollars will reduce your retirement money.
Moreover, Fidelity has found 10% of 401K participants who borrow from these sources to take a hardship withdrawal, resulting in taxes and penalties.
Subject To IRS Limits
The IRS limits 50% of your vested balance, up to a cap of $50,000. Repay the loan within five years. Payments are usually made monthly or quarterly. The loan’s interest rate is generally 1%-2% over the prime rate, currently 3.5%. Besides the borrowing costs, there are likely to be fees charged by the employer.
That loan rate may not sound too demanding to you. Remember, you are borrowing from your retirement dollars and paying it back with after-tax dollars. This withdrawal is a double whammy since you made contributions with pre-tax dollars.
You may have to quickly repay the balance to avoid turning your loan into an early distribution (when you are younger than 59.5 years) if you want to leave your job sooner than five years. Think carefully about an emergency fund that can be more helpful than using your retirement account as a cash cow.
7. If You Cannot Get Unemployment Benefits or Have Volatile Income
If you are self-employed, an independent contractor, or a freelancer, you will not be entitled to unemployment benefits. You may also be subject to irregular earnings, which requires good savings habits for the months when your cash flows dip.
According to the Federal Reserve’s report, 30% of Americans have income swings occasionally to quite often. You need to have a robust emergency fund for those times.
8. Job Loss
The loss of a job within a household can be detrimental. Attaining a new position is dependent on the economy, time of year, the person’s qualifications, experience, demand for his or her skills, potential pay cut, a geographic move (which adds more costs), and age factors.
The duration of unemployment significantly expands during weak economies. As the national unemployment rate rises, your job search will take longer. It doubled during the Great Recession, and many workers took pay cuts, temporary jobs, or did part-time gigs. We hear similar stories due to the pandemic-related recession that is ongoing.
Our Set-Aside Fund Helped Us
My husband, Craig, and I lost our jobs on the same day. Luckily, it was before we had children and our dog. We still had to pay our mortgage and our required bills rather than face hits to our credit scores.
My search took a few months, and I felt quite fortunate. Craig decided to start his law firm. It required upfront spending for his new office for furniture, security deposits, and other costs. Without access to cash, he probably would have had more difficulties setting up his new venture.
9. Financial Support For Aging Parents
As our parents get older, we want to do as much as possible for them. Their medical conditions may worsen unexpectedly. An emergency fund may give us access to funds to help them financially.
Did you know there are 30 states in the US and Puerto Rico that have Filial Responsibility laws that pass the obligation for primary care and needs of aging parents to their adult children? These laws are from England and specifically the 1600s Elizabethan era (where most American laws come from) but very much in place today.
Essentially, these filial laws require adult children to financially support their parents if they are unable to or if there are unpaid medical bills or assisted livings costs that are due. Basic needs include food, shelter, clothing, health care, and medical requirements. Every state law differs and may extend to other relatives.
There is a Yiddish proverb: “God gave burdens; he also gave us shoulders.”
10. Peace Of Mind
Having some money available for emergencies gives us all peace of mind. As sure as death and taxes, unexpected events will occur, and we may not have the money for unforeseen costs. Build your emergency fund to meet that financial burden. The event on its own will likely cause us a lot of stress.
So making financial arrangements will help us have the liquid funds to pay for those costs. Having financial flexibility is having the financial ability to pursue your goals purposefully. It also allows you to take advantage of opportunities as they present themselves during your life. That is peace of mind. Having an emergency fund will help you get it.
5 Ways To Invest Your Emergency Funds
Are you convinced now of your need for an emergency fund? I hope so! Where should you invest your emergency funds? Your family should keep his money in readily accessible and liquid accounts. Liquidity means the ability to convert into cash with little or no loss of principal value. That said, you will be losing money to inflation each year by leaving your money in cash.
Inflation risk refers to purchasing power loss when you will not earn at the same rate of inflation. The average target of inflation is 2% annually. Ideally, you want your emergency fund account to keep pace with the inflation rate.
What Is Not A Good Place To Invest
It is not good to invest your emergency funds into growth stocks because of their inherent risk factors. Growth stocks have higher risk/higher returns and are volatile. They are significant investment assets when you have a long horizon. However, you don’t want to withdraw funds from stock investment accounts when there is a market downturn.
High quality corporate bonds are usually less volatile and provide lower risk/lower return than stocks. You also want these securities for the long term and do not necessarily rely on them for raising cash. The one exception are Treasury Inflation-Protected securities discussed below.
Related Post: 10 Tips To Diversify Your Investment Portfolio
Here are some of my recommendations for investing in your emergency fund:
1. High Yielding Saving Accounts
The average savings account in banks pays minimal interest of 0.10% APY or annual percentage yield. This return is not very exciting though better than keeping emergency funds in your checking account.
A better place is high-yielding savings accounts, whether a financial institution online or at the bank. They generally come with low fees or without fees depending on whether there is the minimum amount required to be kept in the bank. Importantly, your account is insured up to $250,000 at banks by the Federal Deposit Insurance Corp. (FDIC), providing safety and interest for your account.
According to Bankrate, the best high yield savings accounts in July 2019 range from 2.40%-2.55%. Today, these amounts are far lower due to the Fed lowering fed funds rates so check your bank.
2. Money Market Accounts
Another choice is Money Market Deposit (MMDA) accounts consisting of low-risk short-term (one year or less in maturity) money market securities like treasury bills, commercial paper, and certificates of deposits known as CDs.
They are a type of savings account that is FDIC-safe and provides interest rates of 2%-2.50%. Some offer debit and ATM cards along with check-writing abilities. There may be minimums and low fees. Again, rates may be lower, so please check to see what the current is.
3. Money Market Mutual Funds
Money market mutual funds are similar to a money market account as they both contain money market securities. However, investigate sponsored mutual funds by an investment fund company. These funds do not have FDIC protection. They issue shares to investors. The Securities Exchange Commission (SEC) oversees the funds. You can buy a fund containing all government securities like virtually risk-free treasury bills.
Vanguard offers a conservative money market mutual fund for $1 per share, with a low expense ration of 0.16% with a minimum investment of $3,000 with a recent yield of 2.31%.
4. CD Accounts
You may want to consider a CD account rather than a mix of money market accounts, including virtually risk-free treasury bills. A CD account may provide higher interest rates than a mix of money markets and are FDIC-insured.
Buying CDs may reduce your access to this money for some time. They are typically from 3 months-1 year but can go as long as five years. Don’t get locked into five years. The longer the time frame, the higher the interest rates. However, if you need access before the maturity date you may face penalty fees that may defeat your emergency fund’s goal.
5. Treasury Inflation-Indexed Protected Securities (TIPs)
Another option will be to buy TIPS outright from Treasury Direct online or Fidelity if you are concerned about inflation risk. You can also consider a TIPs mutual fund from Vanguard. As their name implies, these securities tracks an inflation index like the consumer price index or CPI. Its yields reset when there is higher inflation based on a formula.
Vanguard has a TIPS mutual fund with an average duration of 2.6 years. It has a minimal expense ratio and a $3,000 minimum and yields a 0.44% return, commensurate with the low inflation risk reflected in our economy. The motivation to put some money into these securities is if you want to keep pace with potentially higher inflation better.
You may want to consider allocating your emergency funds into different accounts based on your preference for safety, liquidity, higher interest rates, and inflation risk. Don’t let these issues become an excuse to delay saving for the emergency fund itself. You have at least ten reasons to inspire you to take control over the “what if’s” in your financial life.
Thank you for reading! Have you put savings into an emergency fund? Do you put savings into your budget?
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.