Your Emergency Fund

It seems all too soon to be discussing stockpiling an emergency fund with Texas unemployment in June of 2020 at 8.6%. These most recent unemployment numbers are a fraction of what they were in April and May but still more than double the Texas January unemployment rate of 3.5%. The coming months are anything but predictable and now is the time re-examine whether your household is prepared for an unexpected financial challenge.

What did your ideal emergency fund look like pre-pandemic? If you are like many, a true emergency fund did not exist outside of some stray money in a savings account. The true ideal emergency fund needs to be more intentional. But intentional in what ways? There needs to be intention around the size and location of your emergency fund. Standard advice says “an adequate emergency fund is 3-6 months of living expenses” but does that standard advice apply to you? I would love to tell you “you need 4 months of living expenses” or “you need $25,000 in your emergency fund” but both of those statements ignore the fundamental truth that personal finance is personal and there is no one size fits all answer.

The Ideal Amount for Your Emergency Fund

Is 3-6 months of living expenses the right amount? A 6-month emergency fund would be double a 3-month emergency fund, so which one is right? It is not that easy; we need to back up. Are you a salaried employee in a stable industry such as a nurse or a tenured professor? Is your income subject to volatility like those paid on commission or those in industries such as oil and gas? Or maybe you are a business owner and the sole income provider for your household? It is not hard to see why the answers to these questions should dramatically change your approach to setting up the appropriately sized emergency fund.

There is no gold standard in personal financial planning that applies to everyone and that is why the appropriate emergency fund could be 3 months of living expenses or 12 months of living expenses or anywhere in between. Look at how this decision might change based on circumstances.

Patrick and Sarah

Patrick and Sarah have been married a couple of years and just had their first child. Patrick is a teacher making $46,0000 and Sarah in a lawyer making $125,000 in Tyler, Texas. They are working to pay off some law school debt and save for both retirement and college for their newborn. The young family only spends 75% of their after-tax income and have been told they need an 8-month emergency fund. Given the stability of both spouses’ income and Sarah’s earning potential at her firm this 8-month emergency fund has a larger opportunity cost than they likely realize. An 8-month emergency fund would be around $60,000 given their spending levels.

If Patrick and Sarah were to cap their emergency fund at 6 month and invest the additional two months ($14,000 in this scenario) look at what the earnings on a 6% compounded annual growth rate compared to a 1% money market rate can do over 10 years. This $10,000 difference in 10 years can go a long way toward funding college for their children or knocking out the student debt along the way. $10,000 over 10 years is not a deal breaker and Patrick and Sarah will need to consider their personalities and preferences, but the decision should be made with intention. Likewise, there would be a projected $10,000 difference over 10 years if Patrick and Sarah were deciding between 4 month and a 6 month emergency fund. 

Bill and Chelsea

Bill and Chelsea have three kids and have been out of school for a couple of decades. Bill has a well paying job in the oil and gas industry and Chelsea stays at home. This family has saved well by fully funding Bill’s 401(k) at work and paying off all non-mortgage debt but only has a $10,000 savings account outside of their retirement accounts. Bill is looking to start his own business in the coming year with dreams of higher earning potential.

Bill and Chelsea likely need a 12-month emergency fund given the volatility of Bill’s industry, that their family only has one source of income, and Bill’s desire to start his own business. Without an adequate emergency fund and all their current net worth in a 401(k) plan, Bill and Chelsea would be forced to take early withdraws subject to ordinary income tax rates and a 10% penalty or take on credit card debt if they had a sudden need for liquidity. This need often comes during economic distress which means the stock market prices are depressed and investment recovery is forfeited by selling at the bottom.

No matter whether the reason is starting a new business, buying a home, going back to school, or wanting to make a difficult career change, cash savings provides flexibility to pursue changing passions and opportunities. While the opportunity cost of overfunding an emergency fund is real, this problem is rather rare in reality. Most families simply need to focus on increasing the size of the emergency fun but doing so should be accompanied by an intentional goal.

Location, Location, Location

The size of the emergency fund is the priority, but location also matters. The best place to start is an online savings account such as Ally Bank, CapitalOne360, or any other “high” interest savings account. The CapitalOne360 money market account has a 1% interest rate in July of 2020 which given the environment is larger than most alternatives. Equally important to the yield on the savings account is that this account is separate from your checking account to reduce the temptation to dip into these funds for non-emergency reasons. It helps psychologically to have a mental moat between your checking account and your emergency fund.

What About Using a ROTH IRA?

In an ideal world you would never need your emergency fund, right? Best case scenario would be that you keep this account funded with your determined monthly living expenses and never touch it again. Savers working to building their emergency fund and are not yet maxing out their retirement account at work should consider a ROTH IRA as their emergency fund vehicle.

The ROTH IRA has annual contribution limits set by the IRS which in 2020 is $6,000 per person. These annual limits do not carryover so if you did not make a 2019 IRA contribution you cannot go back and do so now or in the future. The ROTH IRA is especially attractive because the income inside the ROTH is tax free and all qualified distributions from the account are tax free. In order to take out the earnings inside the ROTH account you must meet certain criteria but you can always take out your previous contributions you made to the account tax free and penalty free. Always.

So, you are contributing $8,000 to your 401(k) at work every year and starting to build your emergency fund? Why not contribute up to the $6,000 annual limit to a ROTH IRA (or $12,000 if you and your spouse both open an account) and invest it in a short-term bond fund? Do not invest these funds into equities or other volatile funds because that would defeat the purpose of the emergency fund. You can always distribute your previous contributions tax and penalty free. What you have effectively done is lock in your annual contribution, so it does not slip away forever while keeping it available in case of emergencies. 

It is important to note that thinking of retirement accounts as available for short-term spending needs is generally not a good idea and you must go into this with your eyes open about what you are planning to do. You never want to adopt the same mindset with your 401(k). So, if blending the IRA and the emergency fund does not provide enough mental separation as using an online savings account then by all means use a high yield savings account. The most important end goal is simply to have a full emergency fund that provides you and your family with the flexibility and comfort needed to weather any unforeseen storm.

Step by Step

  1. Spend less than you make and track what you spend.
  2. Intentionally set an emergency fund size goal for your household.
  3. Consider the ROTH IRA or, if preferred, an online savings account and begin systematically funding the account.
  4. Only allow yourself access to the emergency fund for true emergency needs.