Emergency funds are an absolutely crucial aspect of any financial plan, regardless of the life stage or situation.
For people who already have high-interest-rate debt, having an emergency fund can help guard against resorting to additional high-cost financing in a pinch. It also helps you defray unexpected expenses without needing to raid your retirement accounts.
Finally, the big reason to have an emergency fund is to cover your basic costs in case of job loss.
Step 1: Determine your monthly living expenses
Tally up your essential monthly outlays: housing costs, utilities, food expenses, servicing debt, insurance, and taxes. Don’t include nonessential items that you could live without in a pinch.
Multiply your essential living expenses by three months. This is your absolute minimum savings target for your emergency fund.
From there, you can customize your own emergency-fund amount upward. One of the biggest determinants of emergency-fund size is your career path. Contractors or other workers with lumpy income streams should obviously have bigger cash buffers.
Finally, factor in how much flexibility you have to adjust your expenses downward in a pinch. New graduates who could readily relocate or get roommates can get away with a smaller emergency fund. But if you’re carrying a mortgage, have two car payments, and have children, your emergency fund should be much larger.
Step 2: See how much you have right now
Add up the aggregate investments that you hold in your checking and savings accounts, money market accounts and funds, and certificate of deposit accounts, or CDs. Exclude any assets that you have earmarked for other purposes, such as money that you’re saving for a car down payment. Also exclude any cash holdings in your stock or bond mutual funds. This is your current emergency fund.
Step 3: Set your emergency-fund savings target
Subtract the figure from Step 2 (your current emergency fund) from the figure in Step 1 (your target emergency fund). This is how much you need to save at a bare minimum—double this level or more. Setting money aside to hit this savings target should be your main savings priority in the months ahead.
Step 4: Identify appropriate investments
My advice is to use plain-vanilla cash investments: checking and savings accounts, CDs, and money market accounts. Online savings accounts are often one of the highest-yielding cash options; credit unions also frequently offer decent yields.
As you shop for cash options to populate your emergency fund, remember that not every product type is FDIC-insured. Money market mutual funds, for example, do not qualify for FDIC protection though, in practice, they’ve been quite safe. And remember that CDs carry penalties if you need to get your money out prematurely.
Step 5: Find the right receptacle
Finally, being able to access emergency-fund assets in a pinch is crucial—you don’t want to have to deal with taxes or penalties. For that reason, it’s ideal to maintain your emergency fund outside the confines of your retirement accounts.
However, your Roth IRA can help back up your emergency fund, if need be. While it’s not ideal to use your retirement savings as a piggy bank, you can tap Roth IRA contributions at any time and for any reason.
If you’re a homeowner, it can make sense to augment your emergency fund by setting up a home equity line of credit to use in case of emergency. That way, should you find yourself in a real bind and have to exhaust your emergency fund, you’ll have another safety net in place.
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This article was provided to The Associated Press by Morningstar. For more personal finance content, go to https://www.morningstar.com/personal-finance
Christine Benz is the director of personal finance and retirement planning at Morningstar.
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