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The first step in a successful investment strategy is to make sure you are prepared for financial emergencies. Whatever your investment goal, it's important to set aside money that you can use for the unexpected. Before you do that, you'll need to look at your monthly cash flow so you know how much you can spare each month to fund your emergency account.
Having an emergency account can cover both the unplanned event, such as replacing the transmission in your car, and the inevitable but unbudgeted item, such as repairing the gutters on your house. Without backup savings, you may fall into the credit card trap by charging the expense. Over time, those charges can add up, plus you'll be paying interest on those expenses.
Another hazard of not having money set aside to cover an emergency is that you might be forced to sell stocks and have to pay taxes on securities you sell. Or you might dip into your retirement money-potentially during unfavorable market conditions. And when you use retirement money, you'll be borrowing pre-tax money and paying it back with after-tax dollars. Neither scenario is desirable and will cause you setbacks toward your long-term financial goals.
Do you know where your money goes? Before you can set aside money for a rainy day, you first need to know the amount of your monthly take-home pay and expenses. A good way to track expenses is to write them down or put them into a spreadsheet that lists general expense categories, such as food. Once you've tracked expenses for about two months, you'll be able to tell whether there are areas you could cut back on, such as eating out. It's also a good idea to calculate the percentage of your income your expenses represent-the rule of thumb is that all of your debt shouldn't equal more than 35% of your gross annual income. If you determine that you have some money left over each month, that money could go into your emergency account.
Here are some expenses to consider when determining the size of your emergency account:
A good rule of thumb is to set aside enough to cover at least six months of your living expenses. If you have family members who are solely dependent on you financially, you might want to work toward accumulating enough to cover one year's worth of expenses in an emergency account.
You'll want to choose a readily accessible account for your emergency cash. For example, you may want to invest in a money market mutual fund. Although such investments are not guaranteed, they can provide a degree of relative safety along with easy access to your money. Many allow you to write checks.
Money market funds typically invest in short-term instruments, such as U.S. Treasury bills, certificates of deposit and other interest-bearing securities, which mature in less than one year. They do not pay a fixed rate of return. There are no capital gain tax consequences when you redeem shares in a money market fund, but dividend income from these funds generally is taxable to you when received.
You also might consider an interest-bearing checking or savings account through a bank or credit union.
As you calculate the amount needed in your emergency fund, keep in mind that there may be fees for money market fund, checking or savings accounts, which could affect the value of your account.
A good way to make sure you save each month is to set up an automatic withdrawal from your paycheck to put into your emergency account. By investing a consistent amount each month, you will accumulate money steadily, and you'll be sure to add to your emergency account before you spend money on other items.
If you establish an automatic investment plan, you may want to increase the amount if you receive a promotion or pay raise, or if you pay off a car loan or other large debt.
If you experience changes in your life, such as a birth of a child, job change or purchase of a home, your financial picture will likely change as well, so you may need to adjust the amount of money you'll need in your emergency account.
And don't ignore your long-term financial goals. If you've achieved your goal of creating and funding an emergency account, consider investing money in an account directed at other long-term goals, such as retirement or a college education.
Money Market Fund: An investment in the fund is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in the fund.
This information is for educational purposes only and is not intended as investment advice.