Is your emergency fund too big?

Three to six months of spending: this is the golden rule for emergency funds. But what amount of emergency fund is right for you?

It’s a daunting goal when you start to add up all the items in your budget, but in a real emergency – a layoff, a medical emergency that keeps you from working – most of those items are discretionary. An emergency fund is designed to cover only necessary monthly expenses (read: keep the lights on, not keep your gym membership on).

The danger of making your emergency fund too big

Danger can be a strong word – there is never anything wrong with saving more money. But there is a strategy behind where and how you save, and overcrowding your emergency fund has two downsides.

  1. Your money is not growing. According to conventional advice, the emergency money should be in a regular savings account, where you will earn less than 2% interest. Storing too much money at low interest rates can actually mean losing money to inflation over time. (Recently, however, more experts suggest that emergency money can be invested prudently.)

  2. You could miss out on tax savings. You can contribute too much to this emergency fund and neglect Tax-Advantageous Retirement Account Options like a 401 (k) or IRA. There is a significant opportunity cost here, because this extra money misses the investment income. With 2% interest, you will get $ 400 per year on a balance of $ 20,000. If invested instead, the payouts could be three or four times higher.


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Calculate how much you need

First, note that the three to six month guideline refers to expenses, not income. Even so, it is a wide range. Where you fall on this spectrum depends on a number of factors:

  • Are you a single income household? Aim higher.

  • Is your work closely linked to the economy? Same.

  • Is your income diversified, meaning that one source may dry up but others will keep you afloat? Are there two employees in your house? You may be able to shoot a little lower.

Next, you need to look at your actual expenses. (Hint: it helps to have a budget in place before starting this exercise.) This comes down to the necessary and discretionary spending categories.

  • You can do without almost all of the discretionary items in an emergency situation: cable and other entertainment costs; restaurant expenses; purchases; savings contributions.

  • The exception is the Internet, which you will need when looking for a job, for example.

  • What’s left? Electricity, heating, water; rent or mortgage and car payments; food, health care costs, insurance and debt repayment. Add up how much these costs per month, multiply that by the number of months you want to cover, and you have your target fund size.

Consider other sources of money

In a job loss situation, you will need cash. You can’t pay your mortgage with a credit card. You may also want to cover your emergency fund for expenses that you know are coming – for example, if your roof hits its life expectancy. It can help you sleep at night.

But if you are overfunding to prepare for unforeseen expenses, like the possibility that your dog may need emergency surgery, keep in mind that you may not need the money but rather the money. ‘a way to pay for something in a pinch. And it could be a credit card that you then pay off.

Make no mistake about it: One of the great benefits of an emergency cushion is that it saves you from credit card debt. Going into debt is not the suggestion here. But if your credit cards aren’t in debt, you may be able to put less money in an emergency fund because you can put an expense on the card and pay it off before interest starts to accrue. .

How would you find the money to pay it off so quickly?

  • You could dip into the emergency money that you set aside in the event of a job loss.

  • You can reduce your savings contributions for a month or two; after all, if you’re the type to overfund your emergency fund, you probably have a pretty high savings rate, and that money – even pension contributions – could take a short-term detour.

  • You may have access to the money you have set aside for other purposes (a down payment, next summer vacation).

  • Or you can cut back on that discretionary spending and live a little lean.

Make better use of any excess

If you find that your emergency savings may be reduced, you have other ways to grow your excess money.

  1. Put it in an IRA. In 2020, you can put up to $ 6,000 per year in one of these accounts (or $ 7,000 if you’re 50 or older).

  2. If your employer offers equivalent dollars on your 401 (k) and you don’t contribute enough to win the full game, that’s the # 1 priority.

  3. If you don’t have 401 (k), aren’t getting matching dollars, or already contributing enough to maximize them, the IRA may be your best option. If you choose a Roth IRA rather than a traditional one, there is an added bonus: in a pinch – the emphasis on the pinch – the money you pay could be used for an emergency, because Roth IRA Withdrawal Rules allow contributions to be used at any time.

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About Douglas Mackenzie

Douglas Mackenzie

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