An emergency fund is money set aside for financial emergencies. It seems like a pretty straightforward concept, but there are plenty of things to consider.
Let’s start with defining what a financial emergency is. Usually, it is an unexpected cost that exceeds your budget or take-home pay. These costs can occur within as little as two hours or span several months. A few common financial emergencies are medical situations, job loss, home repairs, and auto repairs. I’m sure we have heard nightmares of emergencies costing thousands of dollars, if not more. This is not to scare you, but to prepare you.
Alright, we know we have to save and prepare for an emergency. Now what? Since thousands of dollars is vague, how much do we actually need to save? It depends. Generally the accepted answer is anywhere between 3 months to 2 years of living expenses. For example, if one month of living expenses is $2,000 then we should have anywhere between $6,000 to $28,000 saved. Personally, I have 1.5 years of living expenses in my emergency fund.
So where do we put all the money? There are many opinions about how to store your emergency fund. There are some people who invest it and others who keep it in a savings account. I am a firm believer of having an emergency fund in cash and in a high-yield savings account. A high-yield savings account is a savings account that pays higher interest¹. By having our emergency fund in a savings account, we are discouraged from withdrawing from it to satisfy our random needs and wants, but at the same time, can access it quickly without any issues during a real emergency.
I know all of you are thinking — how does an emergency fund relate to retirement? Let’s take a look at John’s case below.
It is December 2007 and John has been working at the same Fortune 500 company for over 10 years and recently received a promotion. In addition, all his retirement investments have gone up in value. He got married two years ago and just had his first child, and he is looking forward to a Christmas celebration with family and friends. Life is going great. Fast forward nine months to September 2008 and suddenly, John hears about the financial crisis. Two weeks later, his company lays off everyone in his department.
The above chart illustrates how recessions (shaded areas) are tied to rising unemployment rates. During 2008, the unemployment rate went from 1.5% to 4.4% meaning almost triple the amount of people are out of a job and are actively looking for one. In addition, few employers are hiring during this time so it is going to be very tough to find a job. Unfortunately for John, he doesn’t have an emergency fund and it takes him 10 weeks to find a job². All of a sudden, John is now struggling to pay for his mortgage, baby food, electricity bills, insurance, and other necessities. After doing some calculations, John realizes he needs around $7,500. Without an emergency fund, John has no choice but to withdraw money from his retirement accounts. This is terrible for two major reasons: penalties and less money invested for retirement.
The first reason is that when we withdraw money from tax-advantaged retirement accounts, the government will penalize us. This is to discourage us from withdrawing from retirement accounts before we are 59 ½ years old. It is usually 10%, but can be lower or higher depending on the type of tax-advantaged account.
The second reason is even worse than the first. If we withdraw money from our retirement accounts for any reason, then we will have less money for retirement and less money invested in the market to grow. Remember two of the three rules for investing for retirement are:
- Indexes representing the American economy historically increase over time
- Buying and holding securities are better than timing the market
If you are new or need a refresher for these rules, read more here. Essentially, this means that we are stealing from our future selves.
We should never withdraw from our retirement accounts until we retire. We can and should prepare for recessions and other financial emergencies with a cash-only emergency fund.
Got more questions? Leave a comment or reach out directly, happy to answer and expand. See a mistake? Let us know, we are human after all.
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