One of the worst things that can happen to you if you live in Florida is to have your air conditioning go out during the middle of summer. Often times this means you have the unexpected surprise of having to replace your entire system, which could run anywhere from $3,000 to $5,000. Or, maybe you’re retired and some of your income is coming from rental properties, and then, horror of all horrors, your tenant stops paying rent. Or, you have unexpected repairs to perform on the rental property which will eat up most, if not all, of your rental income.
These are just a couple of examples of why it is so critically important to have a rainy day, emergency reserve fund. You may wonder how much you should have in your emergency fund and where you should put the money? Here are 3 tips to guide you.
We normally tell our retired clients to keep around $20,000 as an emergency fund. If you’re still working, you probably have seen articles that suggest you keep anywhere from 6 to 12 months of living expenses in that emergency fund just in case you lose your job or go out on disability. So which is it, 6 months, 12 months, or something else? Well we say that all depends on your job, your profession, and how difficult it would be to find a new job or employer if you lost your current job. In a recent conversation with one of our clients, when asked how long he thought it would take to find a new job if he lost his current job, he felt it would take less than 30-45 days based on his credentials and the high demand for skilled workers in his chosen profession. So in a situation like this, maybe 3 months of living expenses is more appropriate. So what’s the right amount for you?
Another idea would be to think back over the past 5 years and ask yourself what is the biggest check or unexpected bill that you had to pay. I’ll bet in most cases it’s something less than $20,000. So now you know why we recommend a $20,000 emergency fund for a majority of our retired clients.
So now the question becomes where do you park this money? We hear all the time complaints from clients about earning little, if any interest, if they keep this money in a savings account at a bank or a money market account. In turn, they question us as to what higher interest alternatives might be available. I want to caution you that this line of thinking will probably cause more harm than good. The price you pay to have instant access to your money always has little to no potential for high interest earnings. Consider this an insurance policy that will hopefully prevent you from being forced to sell other investment assets, probably at the wrong time, to come up with a lump sum of money due to an unexpected or unforeseen circumstance that has occurred in your life. Ideally, your emergency reserve fund is not held in any kind of retirement plan. It’s called a non-qualified account meaning when you withdraw principle, there is no tax burden to pay and your paying tax on earnings each year as you go on. So when you pull money from your emergency fund, taxes for the most part are a non-event. However, for a large number of retirees, most, if not all of their money is tucked away inside an IRA or 401k or some other type of retirement plan which means when you withdraw money, you are paying income tax on this money. While it is perfectly acceptable to keep an emergency fund inside your retirement money, this can cause you to pay higher than necessary tax. If this is your situation, you should also have in place a home equity line of credit or a reverse home equity line of credit so you could borrow against the equity in your home for short term emergency cash needs. This would give you time to determine when it’s best, from a tax perspective, to pull money from your retirement account to pay off your equity line.
Oh, and before you go parking large sums of money in your emergency fund, you want to make sure and get rid of any consumer debt you might be carrying such as credit card balances that carry over month to month, car loans, etc. The interest on these accounts is usually 12% or higher and your emergency fund is only going to pay you 1% if you’re lucky. If you have consumer debt, only keep $1,000 in an emergency fund and use the rest of your available cash to reduce, or hopefully eliminate, your consumer debt. I know ‘What if you have an emergency’? Well, you can always go borrow against the car or get a cash advance against the credit card should the need arise. However, save yourself a ton of interest and use any surplus cash you have to pay off or pay down consumer debt. Then, take what used to be your old monthly payments and add them every month to your emergency fund until you reach your target balance.
So, there you have it, 3 tips to deciding what the best emergency fund is for you.
- Determine the right amount for your situation.
- Don’t worry about earning much, if any, interest on the account. Consider this cheap insurance to prevent you from having to sell a valuable asset at the wrong time.
- Build a $1,000 emergency fund and use extra cash to reduce or eliminate consumer debt. Once eliminated, add the old monthly payments back to your emergency fund until you reach your target amount.