Financial Tip Friday: You Need An Emergency Fund

Financial Tip Friday: You Need An Emergency Fund

There are some that suggest you don’t need an emergency fund at all and a credit card or a home equity loan would suffice. For those who offer that advice: I think you are crazy. Why would any logical person go into further debt in an emergency? The old maxim an ounce of prevention is worth a pound of cure is dead on. Not planning and saving for some kind of emergency (even if it is small amount like $500-$1000) is absolutely essential because you never know when it is going to rain and believe me it will rain. It has rained at least once in the past three months and I am glad I had emergency money set aside to help take care of that situation. So there is no doubt that you need an emergency fund of some kind. However, there are several questions surrounding emergency funds.

Question 1: What is considered an emergency?

For me, emergency funds are not to be used when you have small unforeseen expenses, like you didn’t budget this month to go out to dinner or something of that nature. Emergency funds only should be used for true emergencies. Perhaps, your car engine blows up or you lose your job and need to stay afloat until you find another one. Emergencies are those unforeseen items that come up where you have a great need to be taken care of (e.g. transportation or paying the mortgage without income). They don’t happen often, but they do happen and need to be planned for.

Question 2: How much should you have in your emergency fund?

The exact amount differs for different people. Financial gurus will recommend a fully funded emergency fund to consist of expenses that range anywhere from 3 months to 1 full year. For me, my ultimate goal is about three months of expenses because I have a secure job. However, right now I have about $1000 in my emergency fund because I am in debt payoff mode.

Question 3: What qualifies as expenses for your emergency fund?

I think this is perhaps one of the hardest if not the hardest question to answer because when you are creating an emergency fund you have to figure out what your expenses are each month and then use that as a basis to create an amount you are comfortable with. What qualifies as potentially emergency expenses? Some are fairly obvious like mortgage or rent, electric, food, phone, gas, and maybe a couple of others. But what about things like student loan payments, credit cards, car payments, or other payments. In my opinion those are not necessarily emergency items to put in your budget for an emergency fund. I mean if you lose your job and might be out of work for an extended period of time you probably aren’t going to be able to pay your credit card anyway so that would one of the last things on my list. I try to keep my emergency fund expenses to the basics of life, but I can understand why others would include a car payment, student loans, or other items in that list. It is really up to you what you are comfortable with. For me, it is the basic necessities of life.

Question 4: Where do you put your emergency fund?

This is the other difficult question for me. Some people recommend that you have that money sitting in a bank account accumulating interest at .5%. The idea is that those monies are liquid and easily accessible.

My problem with that recommendation is two-fold. First, I hate to see my money only earning a small amount of interest like that. Second, I might be tempted to use those funds to pay off debt or something else. Thus, I would be spending my emergency fund. So my solution is two-fold.

First, I have about $1000 sitting in bank account that I can get access too fairly quickly. The thing is that emergencies rarely require you to pay X amount of dollars right away. Most of the time those emergencies involve expenses that will come in and you don’t have the income to pay for them because you lose your job or you were not given enough money or whatever.

Second, the rest of the money I am putting into my ROTH IRA. I love Roth IRAs and believe everyone should have one. I wish my job offered a Roth 401k because I would be the first to sign up. There are a number of great things about Roth IRAs.

1) When you contribute to a Roth IRA all of the money you contribute and invest will grow TAX FREE!!! Woo HOOO! Now any gains you have on that money you can’t take out until you reach 59 ½, but those monies grow TAX FREE!

2) Any gains that you have in your Roth IRA you do NOT have to take a monthly distribution at 70 1/2. In a regular IRA or 401k or other retirement account you have to take a mandatory distribution when you reach that age. With Roth IRAs you never have to take that distribution. So you can pass that money along to heirs or others if you want.

3) Once you have owned that Roth IRA for five years you can access up to $10,000 that you can use to buy a house. That is a fantastic feature.

4) The most important thing for emergency funds is that you can withdraw the contributions you make ANYTIME! No questions asked. Now you CANNOT withdraw any kind of interest or gains you have earned from your contributions, but your basic contributions (up to $5500 per year) you can withdraw. So let’s say you contribute the maximum each year and you have say $20000 in contributions. You access that $20000 for an emergency. Because a lot of emergencies might involve protracted unemployment or bills that might not require money immediately it doesn’t take long to contact the company you have your Roth IRA with and request your contributions be sent to you in a check or transfer the money into your bank account.

The Roth IRA is one of the BEST, if not the best, way to save for retirement and/or keep your monies safe for an emergency fund. I only wish that I could contribute more every year.

So my two-tiered solution gives me immediate access to a small amount of money if needed and then if I needed to tap some money for a long-term emergency I will be able to get access to those funds fairly quickly.

I think everyone should have a Roth IRA. They are easy to open and the vast majority of Americans can open one up. Now if you make hundreds of thousands of dollars every year you might not be able to too, but the 99% or 95% should have no problem.

The key to any emergency fund is that those monies are for emergencies ONLY! Not for debt payments, not because you had a slow month with wages, not because you want a new car. I have a high threshold for what I consider to be an emergency. If you plan a little now you can be prepared when the rain truly comes.

8 thoughts on “Financial Tip Friday: You Need An Emergency Fund

  1. Hi Jason! Very good advice about Roth. Question: My company offers both a Roth and a traditional 401K. Both are eligible for matching contributions. Which do you think is best? It’s the difference between tax sheltered saving vs. tax sheltered growth. What is your opinion?

    1. Well, that is up to each individual. I would do the Roth b/c it grows tax free. However, your companies match will go into a normal 401k. Contributions from an employer, as far as I know, CANNOT go into a Roth 401k, only the contributions you make. So you have the best of both worlds: tax sheltered savings and tax sheltered growth.

      You might also want to do a traditional 401k and just open a Roth IRA for you and your spouse (depending on your income). I wish we had a Roth 401k at my job because I could do a Roth 401k and Roth IRA. This article might help give you some other answers as well:

  2. Nice post! I’m aiming to top off my Emergency Savings Account too by the end of this month too. I don’t feel the Roth IRA route is the right one for me, especially as a freelance stage manager, the odds of having to dip into my emergency savings because of unemployment are pretty high and I’m happier keeping it liquid. You’re right that Roth IRAs are awesome though because of how much of a security net they provide in so many ways.

    1. Hi Mel, your plan on keeping your emergency savings is totally understandable. Having that money in an account that is easily accessible when the freelance income isn’t as high that month is absolutely essential. In fact, some people might call me crazy for keeping emergency money in a Roth IRA, but because I have a fairly stable income I can park my money there. But I do admit sometimes waffling and thinking I need to have more liquidity. Hopefully, I will eventually get to the point of both.

  3. I believe that everyone’s emergency fund should be catered to their lifestyle. My emergency fund has to be able to cover flying my daughter and I from Japan to the U.S. with pocket money. That is about $4000 alone. If I throw in the added life extras like car repairs and such your talking another $1000. Right now my priority is saving for a downpayment for a home since I’m about to retire from the military, and paying off debt second, so my emergency fund stays at $5000 and that is good for me. David Ramsey says people only need $1000, but I think your emergency fund should be tailored to each person for if I owned a home right now my emergency fund would have to be at least twice the amount I have now.

    1. First, thank you for your service. And I totally agree about emergency funds. Personal finance is, as you say, personal. I think Dave’s advice can be good, but sometimes having more money is needed for greater security. Good luck on saving for your house. I loved your story and can’t wait to get that debt free martini someday/

  4. As someone using my emergency fund currently , I can’t seem to feel 100% secure putting it in the stock market. I was out of a job in 2008 due to a company closing. While large companies in my industry aren’t likely to go under, mergers and buy-outs do occur and the stock market can have an effect. I keep my emergency fund in an online account that takes a few business days to transfer, which helps me evaluate if I ought to be using the money. I have 6+ months, which is coming in handy. 🙂

    1. I can certainly understand that. I put it in the market with the idea that we wouldn’t need it b/c I have a pretty stable job. Unfortunately, I actually liquidated it to pay our taxes (it wasn’t a total fund anyway). Now I just keep $1000 for immediate emergencies, but after I pay off my loan this is the next item to increase in our journey to FI.

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