If you embrace my money management strategies, there’s not a lot of wiggle room in your budget. Savings are taken off the top of every paycheck, and sometimes through no fault of your own you simply can’t afford to live on what’s left over. That’s what an emergency reserve fund is for.
How much should you put in your emergency reserve fund? “Save three to six months of living expenses in your emergency reserve fund.” That’s the old standby us financial planners like to throw around. After living through the pandemic, I’m thinking for a lot of people maybe that’s not enough.
Whatever amount makes you sleep a little bit easier at night, that’s the amount you should put in your emergency reserve fund. If you’re confident your current income stream will continue and your financial house is in tiptop shape, leave the amount where it is. Up it a few months of expenses, or up it to a year or a year and a half if that makes you feel better. Don’t fund it with too much, though. This money must be kept safe and available, which means your return on investment is going to be minimal.
What’s an Emergency?
True emergencies are, well, they’re emergencies! You lose your job. You must pay a big, unexpected medical bill. Your house is flooded and there is a large deductible to pay. Your hours are cut back because of a world-wide pandemic.
What’s Not an Emergency?
This is when having an effective budget comes in handy. Your budget should allot for a vacation, minor car repair, getting a leaky sink fixed, and expenses for extra-curricular school activities. In a perfect world, those expenses and more are anticipated and budgeted, and you never have to tap your emergency reserve fund. You do the best you can.
Where to Stash It?
The nature of an emergency is such that you never know when one is going to happen. That’s why you need to keep your emergency reserve fund liquid and safe.
Being liquid means that money is available quickly and when you need it most. As an example, it can’t be tied up in a certificate of deposit or CD, where there is a penalty if liquidated before the maturation date.
The money also needs to be safe. If you need 6 months of living expenses, the money had better be there. For example, if you invested your emergency reserve fund in stock, and the stock market is currently going south and now it’s down to just 2 months of living expenses, that could be a problem.
There’s something to be said for convenience. Open a savings account or a money market fund—both good candidates for your emergency reserve fund—at your local bank. But what rate are you earning? Many big banks pay abysmal rates, many times less than others. It’s not much, you say. Rates are so low now it’s not going to make any difference.
It may appear as a small difference. But when you start adding up a higher rate here and lesser expense there in all areas of your saving, spending, and investing, it makes a huge difference, especially over time. So don’t settle.
Seek out higher rates of return, including where you stash your emergency reserve fund. Like I said, a high interest savings account or money market type of an account are candidates. The good ones not only pay a higher interest rate than most, but also carry FDIC insurance. Not only is your cash invested in a super-safe investment that is subject to little risk, but it’s also insured by the federal government for $250,000 per account, $500,000 if it’s a joint account.
Where do you find these higher rates of return? I’ll let you do your own research. In this era of big data, assuming you can navigate through the advertisements (which you want to avoid), it’s easy to find the higher performing ones that carry FDIC insurance. Bankrate.com is one of the many sources of information you’ll come across in your research.
You’ll notice many of those offering higher yields are online banks, which probably don’t have a brick-and-mortar location near you. This is where you may have to give up some convenience for utility. Still, establishing an online account with an electronic transfer link to your local bank account gives you access to your money in just a few days. Many accounts offer even faster and more convenient access via debit card or check writing capability.
If you’re a more aggressive investor, you still need to follow the rules as far as choosing a safe and liquid investment. If you want to shoot for a slightly higher rate with just a little bit more risk, consider an ultra-short bond ETF, like the one offered through Vanguard®.
Incorporate Your Roth IRA
If you’ve made plenty of Roth IRA contributions in the past, you’ve created a big pool of money from which you can draw in the case of an emergency. You don’t have to be age 59 1/2, or for that matter even have a good reason for making a withdrawal. I’ve found a lot of people don’t know that.
I’m not talking about your earnings (interest, dividends, and capital gains): Those do have to stay in your account until at least age 59 1/2 to be able to withdraw tax and penalty free. I’m talking your principal contributions only.
Still, a Roth IRA is a sweet investment vehicle that you’d rather not tap until later if you can help it. That’s why I personally kept my emergency reserve fund, but I reduced the amount I keep in it by half. Over the years, I’ve tapped my emergency reserve fund more than a few times. I’ll even admit to not being able to live on what’s left over a time or two. I observed these expenses ate into the first half of my emergency reserve fund, but rarely did I have to tap the latter half.
Assuming my good fortune continues, that’s my logic behind utilizing both. If you’re more disciplined than me and you don’t think you’ll ever tap your reserve, you might want to give up your emergency reserve fund altogether. Either way, you can expect a much higher rate of return in your Roth IRA than in your emergency reserve fund. Just another way to squeeze some more utility out of your money.
Only use this strategy if you have a not-so-risky element in your Roth IRA investment plan. For example, I don’t want my daughter, who’s in her early thirties, using this strategy. Even though she’s made plenty of Roth IRA contributions she can access tax and penalty free, her risky to not-so-risky ratio is set at 100-0 (100% risky) in her Roth IRA. If a down stock market and expensive emergency struck at the same time, she could be faced with liquidating stock at bargain basement prices, something no investor ever wants to do.
By the way, an all-risky portfolio in my daughter’s case is not considered overly aggressive given she has an investing time horizon of 25-plus years. As she ages and her time horizon decreases, she’ll start to add more and more conservative investments to the mix. Only then would this strategy make sense.
After raiding it try and replace it if you can or rebalance if you’ve already exceeded the maximum Roth IRA contribution limit for the year or are over the Roth IRA AGI limits.
Everyone needs their own version of an emergency reserve fund. As always, seek out higher rates of return, keep your expenses low, and be on the lookout for better solutions.