You’ve probably heard it before: the very first aspect of financial security is having an adequate emergency fund.
Having proper cash reserves can solve a multitude of life’s expected problems, whether your transmission blew up while leaving for your family’s cross-country road trip or your job got the axe in the latest round of layoffs. But how much should you keep in reserve for emergencies? And where’s the best place to put that money in the meantime?
While individual situations vary, there are basic principles that can guide you through any of life’s situations.
How big should my emergency fund be?
The most common rule of thumb you’ll hear is to save up the value of 4-6 months of your expenses.
This number works best for people currently working. It’s typically enough to replace a car or roof, or carry a family while they transition between jobs. Without these reserves, you may be forced to put those expenses on a credit card, HELOC, or take an early withdrawal from a 401(k) with penalties attached, all of which are expensive. Not only can your emergency fund help you save money, but it can provide invaluable peace of mind.
If you are retired, you may need much more than 4-6 months in your cash reserves.
If your income primarily comes from fixed income sources like a pension or Social Security, and you spend most of it each month, cash reserves are the source of needed flexibility for any unexpected expenses. Without that emergency fund, you could find yourself saddled with unwanted debt to make ends meet. However, those who need the most cash reserves are retirees drawing the bulk of their income from an investment portfolio.
A proper investment portfolio will be heavily diversified across both stocks and bonds, with the goal to generate income from the portion that is doing the best. Usually that works out just great, but there are occasionally periods where both stocks and bonds suffer. In order to prevent “selling low” during those times, a retiree needs to be able to generate income from their cash reserves. Having 2-3 years’ worth of expenses in cash will ensure that you never have to cannibalize your nest egg during downturns.
Where should my emergency fund be?
The most basic emergency fund is a stack of cash under your mattress. In today’s modern world, there are quite a few ways to improve on that method. There are three basic principles to weigh when choosing where to put your emergency cash reserves. They are:
- Preservation
- Liquidity
- Rate of Return
When it comes to your emergency fund, rate of return is subordinate to the other two principles.
In other words, we should restrict our possibilities to those both safe and liquid, and then begin to factor in return. Many people opt for a savings account at a bank or credit union to keep things simple, but in doing so often leave potential returns on the table. To start, many banks offer promotional rates for opening an account, and many online banks can offer rates permanently higher than their brick-and mortar equivalents. Many people try to enhance the return through a series of short-term CDs with their bank. Please note that liquidity can be impaired in such a strategy. Banks charge fees for taking our money out before the CD matures, so timing withdrawals becomes important, and life’s emergencies tend to not cooperate with such timelines.
At IMAFS, we recommend to most of our high net-worth clients that they deposit their cash reserves in a short-term municipal bond fund, such as the Vanguard Short-Term Tax-Exempt fund (VWSUX), which yields higher than a typical savings account or money market account and pays out tax-free interest.
More important than the location of your emergency cash reserves is that you accumulate emergency cash reserves in the first place.
The best time to start accumulating your reserve is today, and the worst time is putting it off until tomorrow. Consider sitting down with a fee-only financial adviser to help you determine how much and where to gather into your cash reserves. At IMAFS, we are fee-only advisers who consult on your entire financial life, including cash reserves, investments, retirement planning, tax strategy, insurance planning, and more. Schedule a no-cost consultation today.
