Emergency Funds: Why Everyone Needs One and How You Can Build One

Before you can start investing for retirement or passive income, you must have a solid emergency fund that can keep you safe in difficult times. Though it may seem difficult to save for, remember that building an emergency fund is something you only have to do once in your life. Once it’s there, you can basically just leave it alone and focus on building wealth.

That said, there is one class of people who are temporarily excused from building an emergency fund: those who have high-interest debt (let’s say 8% interest rate or higher). For you, getting rid of that debt has to be priority one –  so you’ll have to keep a smaller amount of cash on reserve. We will cover credit cards and debt in depth in a future article.

So what is an emergency fund? An emergency fund is having a certain amount of wealth kept in cash just in case. Just in case…

  • you lose your job
  • your place of work goes out of business
  • you have to take an emergency leave from work
  • you are victimized by identity theft
  • the market takes a dive and your passive income dries up
  • etc.

Long story short, there are plenty of reasons why. Even if you have a high-paying, seemingly solid job – you need an equally solid emergency fund that can help you survive a temporary difficult time. You truly never know when you may need one. If you maintain a well-built emergency fund, you’re not going to be in the percent of people who get their lives ruined because one terrible, unexpected event crushed them financially.

So the big question with emergency funds is how much? To answer that, as the Greeks say, you must know thyself. Expert generally recommend saving enough money to cover your basic expenses for 3-6 months. Whether you save 3 months or 6 months depends on your situation. I want you to ask yourself the following questions:

  • How secure is my job? If I lose my job, how is the job market? How long will it take to find a new job?
  • In a bad situation, can I live with family/friends until I get on my feet? Will they help me out financially?
  • Do I have debt that needs to be paid every month?
  • Do I have children or others that are depending on me to survive?
  • How much passive income do I have? (passive income is income off of investments, not a job)
  • How much money have I contributed into a Roth IRA? (I’ve got more to say on that below)

If you answer all those questions feeling super confident about your financial situation, 3 months of expenses in an emergency fund is probably good enough. If, however, you’re like most people and you feel a little less confident, consider saving more money in your emergency fund. It’s always better to be too conservative. And don’t worry, as you improve your financial situation, you can always revise the amount in your emergency fund. Remember, we are crusading for financial security here.

A special word on Roth IRAs…

We are going to cover Roth IRAs in depth in a future article, but basically they are a retirement investment account that you can contribute to annually. You contribute after-tax funds into it, but when you withdraw those funds (which have hopefully grown over the years), you don’t have to pay any more taxes! Not even on the gains. For this reason, Roth IRAs are extremely tax advantageous and thus the IRS limits your contributions to $5,500 a year. One other cool perk of Roth IRAs is that you can withdraw your contributions anytime tax and penalty-free! In other words, if you contributed $10,000 that grew to $25,000 – you can withdraw your original $10,000 without penalty. The remaining $15,000 has to stay in there though (unless you want to be penalized). For this reason, some people recommend counting your Roth IRA contributions as part of your emergency fund.

While it is true that in an emergency you can withdraw your IRA contributions, you can’t just put those funds back in. After the funds come out, you will only be able to recontribute up to that same $5,500 limit per year. So if you have $50,000 of contributions in your IRA and you withdraw them in an emergency, fine. But now if you want to put those funds back in 6 months later – you can’t. You just lost the tax benefit you were working toward over several years of contributing to a Roth IRA. Additionally, you technically should not invest any funds in your Roth IRA that you want to consider being part of your emergency fund. For both of these reasons, I do not recommend including your Roth IRA contributions in your emergency fund.

But then why did I ask how much you had contributed to a Roth IRA previously? Well, although I don’t think your Roth IRA should be part of your emergency fund, I do think it plays an important role in determining how financially secure you are. If you have a lot of Roth IRA contributions ($), you are more financially secure because, as I outlined above, you could withdraw these funds if needed (at the expense of your retirement). So, in short, consider your Roth IRA contributions in determining how many months of expenses you keep in your emergency fund, but do not confuse your Roth IRA funds with your emergency fund. Your Roth IRA funds are for your retirement and they should be fully invested for that purpose.

Back to Determining the Size of Your Emergency Fund

So at this point you should have decided how many months of expenses you need in your emergency fund. Importantly, do not revise that once we finish this calculation. So the next question is: how much are your basic expenses per month? The biggest expense, of course, is rent/mortgage so start with that. After that: food. If you think you could cut down on your food expenses in an emergency, calculate what you think you could reasonably spend on food. You should first have a good awareness on what you currently spend through a free service like Mint.com that can quickly categorize your expenses. I’ll leave it up to you to determine the rest (remember, know thyself). But some common items are: utilities, transportation, alcohol/events, toiletries, clothing, etc. You don’t have to use the amount you currently spend – just the amount you think you could reasonably limit your spending to in the event of an emergency.

Now take your number of months and multiply it by your calculated amount of monthly expenses and… bam! There’s your emergency fund number. If that number seems big, I will remind you that you only need to build your emergency fund once. After it’s there, you never have to save for it again (hopefully).

Now… Where to Keep Your Emergency Fund

Don't keep your money there, Walter White.

Don’t keep your money there, Walter White.

I’m going to say that people can be split into two groups – and hey, no judgement here. The groups are: (i) those who consistently spend the same amount as they make or spend less; and (ii) those who are… less consistent. If you find that after months of spending and making money, your bank account ends up around the same or is always growing, you’re Group 1. The rest of you, Group 2.

If you’re Group 1, great news, you can keep your emergency fund in the same checking account you spend money out of and cash your paychecks into. After all, since you are consistently not spending more money than you make, your emergency fund is safe.

For those who are less consistent or know they will always dip into an emergency fund if it’s there, you have to keep your emergency fund out of reach. This means keeping your emergency fund in a separate checking/savings account than the one you use to spend from. The good news for Group 2 folks is that you can invest your entire emergency fund in a high-yield savings account. A high-yield savings account is typically a no-frills, online-only savings account that pays much better interest rates than your standard bank. I use American Express Personal Savings because they pay an interest-rate of .90% and are a reliable bank. They don’t provide debit cards and limit your withdrawals per month – perfect for an emergency fund! If you need funds out of it, you have to transfer it into your spending account. There are other several other high-yield checking/savings accounts that a Google search will turn up too. And do not put your emergency fund in a CD or other investment options – the whole point of an emergency fund is that you can take it out immediately if you need it.

Back to Group 1, did you overhear me talking about high-yield savings accounts? Well don’t worry, you can get in on it too. Of course, you can go the Group 2 route and keep your emergency fund separate from your spending account (that’s great). If not though, I recommend keeping at least 2 months-worth of expenses from your emergency fund in your spending account and the remaining months in your high-yield savings account. This is just so you have enough money in your spending account to take care of… your routine spending! But remember, this is still your emergency fund so make sure you are always making enough money to cover all your expenses.

There You Go!

Now you know the basics of keeping a good emergency fund. You should know the number of months you are going to cover for, how much money that is, and where you are going to keep it. You’ll even be able to grow it a little through the interest on your high-yield savings account. You’re on your way to financial security. But if the idea of building the emergency fund still seems daunting, luckily next week we are going to cover saving and managing your overall financial picture. Until then, there will be a new Stock Analysis Thursday article up on… Thursday. Have a great Tuesday!

Disclosure: I am not a financial advisor. Do not make any decision solely based upon what you read here. It’s your money, invest it wisely.

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