Financial security isn’t just about accumulating money, it’s also about how you spend it.
Income is only one factor. Someone making a six-figure salary can find themselves drowning in debt, while someone with a modest income can have a rock-solid financial foundation. The difference lies in your ability to plan ahead.
The first step to building financial stability is to set up an emergency fund. Here’s what you need to know about how much you need and why.
Reasons to Have an Emergency Fund
Most people know they should have money set aside for a rainy day, but finding the motivation to plan for it can be hard. If your job is stable and you live within your means, why have thousands of dollars stashed away?
When it comes to saving, the “why” is just as important as the “how.” Having financial padding for the unexpected can help you get through hard times.
If you’ve never been laid off or unemployed, it’s easy to underestimate just how difficult things can get while in between jobs. Income can stop but bills don’t. According to the Bureau of Labor Statistics, the average length of unemployment in 2019 was 21.6 weeks.
Use this interactive PDF to calculate how much you may need in your emergency fund to cover 12 to 24 weeks of living expenses.
Most experts recommend an emergency fund that covers 12 – 24 weeks’ worth of expenses after a job loss. To calculate the amount you need, add up all your regular fixed expenses. This may include housing, transportation, health insurance, car insurance, student loans, utilities, internet and any other necessities.
Next, write how much you generally spend on variable expenses like groceries and gas as well as non-essential expenses such as takeout or video streaming. The sum of your fixed and variable expenses is your monthly expense total. Your emergency fund needs to cover essentials at the very least.
Caring for aging parents can be a big time commitment and strain finances. A study from Harvard found that 32% of all employees voluntarily left a job because of caregiving responsibilities.
If you anticipate being a primary caregiver to your parents or other relatives (or already are), you need an emergency fund. With a fund, you’ll be able to pay your bills even if you need to cut back or leave your job completely.
Most people don’t consider the possibility of being affected by a physical or mental disability. But according to the Council for Disability Awareness, more than one in four of today’s 20-year-olds will be disabled for at least a year before retirement.
If that sounds alarming, you might want to consider long-term disability insurance. These plans can help cover expenses after you’ve been disabled for 90 days. But you’ll still need an emergency fund to bridge the gap for the first three months.
Short-term disability insurance typically covers 80% of three to six months of income and kicks in after an injury or illness (with a waiting period). It can be expensive to buy on your own and some employers offer as a benefit.
Long-term disability insurance usually covers 60% of income for any number of years up to retirement (also with a waiting period that can be lengthy). It’s more affordable but with lower benefits. Pairing up this coverage with an emergency fund is critical.
Thinking of Using Retirement Money? It Can Set You Back
Creating an emergency fund can take months or years, especially if you run into setbacks and need to use those savings. But the risks of not having one can be greater.
While some accumulate credit card debt or take out loans in an emergency, others may draw on retirement or other long-term savings. Investors with an IRA who are younger than 59½ can withdraw those funds, but may face a 10% penalty as well as income tax. Even without the penalty or taxes, whatever future plans you may have had for your IRA money can be derailed.
Similarly, parents who have a 529 account for their child’s college education can withdraw money for emergency reasons, but will owe income taxes and a 10% penalty. Not only that, but the college fund will be depleted and it’s difficult to build that back up.
How to Start Saving for an Emergency Fund
Take a look at your budget and see what you can cut, either temporarily or permanently. The recent health crisis has made some re-examine their spending. One tip to make saving a little easier is to create an automatic transfer to your emergency savings fund. Also, add any windfalls, such as a tax refund, stimulus payment or bonus from work, to your emergency fund savings. If you pay off a car loan or refinance your mortgage to a lower monthly payment, add that amount (or a portion of that amount) to your emergency fund.
Having an emergency fund can ease the financial stress that emergencies cause. As you go over your finances don’t hesitate to call us or request a call. We’re here if you need help.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.