When it comes to building the foundation of your financial life, saving up an emergency fund is usually high on everyone’s list of priorities. The reason being, we all know life throws unexpected expenses at us, and we need to be prepared for it.
Although most think of an emergency fund as being used to replace the broken refrigerator or air conditioning unit, the biggest reason is to replace income. What do I mean by replacing income? In the event of a long-term disability or loss of employment, you will need money to pay the bills while you figure out your next course of action.
Hopefully you have a long-term disability insurance policy, but even then you will need to have savings available to pay the bills during the 90-day elimination period. The elimination period on your disability insurance policy is the time between when the disabling event occurs and when your policy begins to pay you. This is usually a minimum of 90-days, if not longer.
In the event of unemployment, maybe you will receive a severance package from your employer, but will it be enough to cover you until you find your next paycheck? This is very hard to predict, which is why you’d rather be on the safe side and have an emergency fund available.
Most often, an emergency fund of 3 to 6 months of expenses is sufficient. This money should be somewhere extremely safe and available at a moments notice, like a high-yield savings account, Certificate of Deposit (CD), or Treasury Bills. Are you disappointed in the low interest you’ll be earning in these vehicles? If you ever need to tap into your emergency fund, you won’t think twice about the missed investment opportunities.
The exact amount of an emergency fund is different for everyone, and greatly depends on your current level of savings and income sources. Does your household rely on one source of income from one employer and have a large mortgage payment to make? You need a larger emergency fund. Does your household have a number of different income sources, no debt, and lower level of fixed expenses? Congratulations! You can get away with a smaller emergency fund, but you still shouldn’t eliminate it entirely.
Your retirement accounts are for retirement, do not use your retirement savings as an emergency fund.
Yes, there are certain provisions in the various retirement accounts that allow you to access your money if needed during times of hardship, but do not let this be an option. Hardship withdrawals from retirement plans still come with a 10% penalty and an even nastier tax bill.
Your emergency fund will come in handy sooner or later. It is on the priority list of every financially savvy person I know, as it keeps them from having to take on consumer debt if/when the time comes their monthly bills are larger than their monthly income.