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Financial Literacy 101: How Much Emergency Funds Do I Need?

April 16, 2020

Personal Finances
Apr 26

Nobody expected this quarantine situation, and nobody realized how long it would be until the state-wide orders kicked into effect.

All of a sudden, zombie apocalypse didn’t seem so unrealistic anymore, and many began to re-evaluate their financial situation, especially when it comes to maintaining a lifestyle and responding to potential emergencies.

You’ve certainly heard of Murphy’s Law.

A shorter version of this famous philosophical statement is: something you don’t like will always happen.

That’s why it is so important to manage your personal finances and stay financially prepared by setting some emergency funds aside.

The Purpose Of Emergency Funds

The point of having an emergency fund is, naturally, so that you can respond to unexpected situations, whether it is one or more household members lost the ability to generate income, or an unfortunate turn of events, or a medical emergency.

However, there is another significant purpose of emergency funds that often gets overlooked.

That is…

So you don’t have to touch your retirement savings or 401(k) in response to the emergency.

Pulling money out of your 401k early will result in a heavy early withdrawal penalty tax. The amount you pulled out from your account will be considered as income on your tax return by the end of the year, and therefore… you will need to pay income tax on that portion of your savings simply because you pulled it out.

On top of that, you will have to pay an additional 10% of tax as penalty on the amount you’ve withdrawn.

Sounds terrible, right?

Then what if you come up with money in a different way, like selling bonds?

Well…

In the world of investment management, nothing is worse than selling in response to an emergency, whether it’s a panic sell, or simply selling prematurely.

The point of having long-term investment items such as bond mutual funds is so it can bring in stable returns. Selling a long-term investment item because you are in need of cash will inevitably damage your profitability from your long-term investment portfolio.

Thus, there are two purposes of setting aside emergency funds:

So you can respond to an emergency and still stay above water

So you don’t have to disturb your existing investment and saving plans and avoid long-term loss and penalties from the IRS.

How Much Do I Need?

Of course, everyone will have a different idea on the amount he or she needs if something were to happen, because everybody has a unique lifestyle and values different aspects of life.

For example, a parent’s priority is often feeding the child, whereas a business owner must consider covering overhead costs during an emergency. If someone has a family member who has specific medical conditions, the cost of sustaining necessary treatment is often a priority when it comes to how much funds are needed.

However, there are a few simple rules you can follow when it comes to determining how much you need as your emergency fund.

Minimum: Three Months Of Living Expense

If you’ve been doing a good job tracking your expenses, you should be able to easily determine what would cost you to live for three months without any income.

If you haven’t been tracking or budgeting, your bank and credit card statements are always a good place to start.

But keep in mind that we are looking at essential expenses, such as rent, mortgage, car payments, basic groceries and utilities. Because in the time of an emergency, you should naturally start to control and reduce your spendings.

Solid: Six Months Of Living Expense

This is extremely important especially if you have dependents, such as children or elders.

While in the worst case scenario, having six months of living expenses saved up allows you and your dependents to survive throughout the whole six months - which also gives you more time to come up with alternative solutions to ease the impact of the emergency, but most importantly, it also allows you to respond to other correlated risks.

As how the Chinese idiom goes: Bad things happen together and misery loves companies.

For example, what if you just lost your job, and the next week your kid needs to go to the doctors for an accident or a sudden illness because things like that just happen in life?

With six months of expenses saved up, you will have the capability to slightly “overspend” at times when it is absolutely necessary.

But Don’t Overdo It!

“Then wouldn’t it be the best that I have as much set aside as possible?” You may ask.

And the answer is no.

In the long run, we don’t want to live under an emergency state. Eventually, the goal of managing your personal finances is almost always to maximize your return on investment, and at some point, allows you to retire while maintaining a beautiful lifestyle.

When you have a fixed amount of money to split between investment, retirement and emergency funds, overfunding one meaning reduced funding for the others - simple math, right?

Because emergency funds are often deposited into a regular savings account with minimum rates (you can find a list of savings rates of major banks in the US here), overfunding your emergency account means losing the benefits from higher interest rates on the other accounts. It also means losing dividends from your investment portfolio because you are limiting the amount you invest by putting the focus on your emergency account.

Where Should I Save It?

Since we mentioned interest rates, let’s dig a bit deeper on where you should be saving your emergency funds.

Bottom line, your funds must be accessible. This means you must be able to either transfer, or withdraw your funds when needed.

You can choose to open a regular savings account with one of the major banks with a much lower interest rate (usually no more than 1.0%), or open a high-yield savings account with one of the credit unions, as long as you are certain you can easily access your funds both online and offline.

To find out more about what type of account (and with what institution) you should deposit your emergency funds to, talk to a professional financial advisor and let them know you are looking into building an emergency stash.

We are at a high-stress time right now, which means we don’t know what may happen the next day. On a positive note, the uncertain raises attention to financial wellness.

Therefore, if you haven’t considered building an emergency stash, now is the perfect time to get started.