A pile of emergency money is about preparing for the unexpected-and it's about peace of mind. This peace of mind comes at a price. Because you will likely stash your emergency money in relatively low-risk investments, you won't earn particularly good long-run returns.
The implication: You don't want to have more emergency money than is really necessary. Your goal is to make sure you're covered-without going overboard.
Gauging your need. Your emergency fund is there in case of misfortune, whether it's losing your job, replacing the furnace or repairing the car. How much emergency money do you need?
One rule of thumb says it's prudent to have six months of living expenses stashed in conservative investments, such as a savings account or a money-market, with these investments held in a regular taxable account. If you're looking for an attractive place to invest all this money, check out current yields at www.bankrate.com.
Sound like a heap of dough? It could be. If you earn $60,000 a year, six months of living expenses might amount to $20,000 or more. That's a serious chunk of change-and it could take years to save that much.
Before you throw up your hands in despair, however, give some thought to whether you need that much emergency money. Yes, if your job is tenuous and you are the family's sole breadwinner, keeping the full six months may make sense.
But if both you and your spouse work, you may need less, because you can always cut back spending and live on a single paycheck if one of you loses your job. A caveat: The smaller emergency fund may not be prudent if there's a risk you could both lose your job at the same time because, say, you work for the same company or in the same industry.
If you've managed to amass a moderate amount of money in your regular taxable account, keeping a separate emergency reserve may not be necessary. For instance, you might have money in your regular taxable account that's earmarked for your children's college education or for your own retirement. If you lose your job, need to make major home repairs or get hit with steep medical bills, you could always dip into these investments.
Snagging cash. There are also other sources of emergency money. Need a big wad of cash? Here are some options:
You could tap into your home's value through a home-equity line of credit. Be sure you apply for the credit line now-before you lose your job and no longer appear creditworthy.
If you have cash-value life insurance, you could borrow against the policy's cash value. Policy loans don't have to be repaid. But it's usually advisable, because the loan-plus the interest charged-will reduce your policy's cash value and its death benefit.
In addition, if you don't repay the loan plus interest, your policy could lapse. If the total amount withdrawn exceeds the premiums paid for the policy, the excess would be taxable.
If you have a brokerage account, you could borrow on margin against the value of your securities. Be warned: This borrowing will magnify your losses if your account loses value. Indeed, in a bear market, your account's value could drop sharply, generating a margin call-and that might force you to sell stocks at the worst possible time.
You might borrow from your 401(k) plan. This, too, can be a risky strategy. If you lose your job and you can't immediately repay your 401(k) loan, it will be considered a distribution, triggering income taxes and probably a 10% tax penalty.
Sound bad? It might not be as bad as you imagine. If your employer offers a 401(k) matching contribution, you may still come out ahead funding the plan and getting the match, even if you later have to cash out the account and pay income taxes and tax penalties.
By funding a Roth IRA, you can save for retirement and build up an emergency reserve at the same time. Suppose you stash $5,000 in a Roth this year. If you get hit with a financial emergency, you could pull out this $5,000 at any time. As long as you don't touch the account's investment earnings, there would be no taxes or penalties owed.
Ideally, you would leave your Roth to grow untouched until retirement, so you get the most out of the account's tax-free growth. But if you need it, the Roth offers surprising financial flexibility.
Prepping your finances. As you ponder how you might cope with a financial emergency, don't just consider where you'll turn for cash. Also look to keep your cost of living under control.
For instance, you might aim to keep your core living expenses at 50% of your pretax income or less. These core living expenses consist of things like mortgage or rent, consumer-debt payments, utilities and food.
That means the other 50% would be going to items such as income taxes, monthly savings and entertainment. Presumably, if you lost your job, these other expenses would largely or entirely disappear-and you could get by on half of your old salary.
To further reduce your cost of living, consider raising the deductibles on your homeowner's and auto insurance and extending the waiting periods on your disability and long-term care policies. Thanks to your emergency fund, you now have the money to pay for financial mishaps, so presumably you don't need quite so much insurance coverage.
The higher deductibles and longer waiting periods should lower your premiums. Indeed, with any luck, the savings on your insurance premiums will compensate for the low return you're earning on your emergency money.
Source: Jonathan Clements, Director of Financial Guidance, Citi Personal Wealth Management.
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