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Do I Need An Emergency Fund? (Part 1) March 29, 2007

Posted by pf in Expenses and Savings.
Tags: , , , ,

– I have been reading and participating in a number of posts regarding this topic and thought I would go ahead and use a bit more space to provide my own views / perspectives and offer an alternative to the conventional approach.

Why You Need “Emergency” Funds

Everyone knows that life includes the unexpected which includes anything from unplanned car repairs to job loss or major illness. Without reasonably available access to funds for such an emergency, you may find yourself in a very precarious position financially.

What Constitutes an “Emergency”?

Honestly, I don’t think you can provide a definitive definition for what is an “emergency”. Depending upon your current financial status and personality, it will vary. For example, an unexpected bill for $500 may create a financial “emergency” for one person while only being a slight annoyance for another. I think each person needs to define what creates a financial “emergency” for them. Once defined, you can then think about what actions are needed to protect yourself from these types of “emergencies”.

For myself, I define an emergency as lengthy job loss, catastrophic illness, or other disaster which would either severely impair my ability to earn income or create financial obligations that put significant pressure on or exceed my resources to pay it.

How much do I need and how soon do I need it?

If you research the topic, I think you will find that the most common advice is to have accessible resources for 3-6 months worth of living expenses and building it up over time as best you can (ex: small monthly increments). As a general guideline, I don’t think this is an unreasonable starting point. However, when trying to come up the right answer for your individual situation, there are some things you should consider:

  • How quickly / easily could I replace any lost income?
  • What is my ability to generate additional income?
  • Likelihood of experiencing an emergency (ex: your job may be more volatile)
  • Who do I need to provide for? Just myself? Others?
  • What safeguards do I already have in place to protect me in the event of an emergency? (ex: various insurance such as long term disability, etc.)
  • What other options are available / accessible by me? (ex: credit, loans, retirement savings, etc)
  • What will allow me to “sleep at night”?

What Should Be My Plan for Funding What I Need?

This is where I think the controversy begins. Up to this point, I think people can generally agree on the following:

  • Unexpected “emergencies” happen
  • It is a good idea to have funds accessible to help “weather the storm”

Most of the information available suggests setting aside monies specifically for the purpose of an emergency and that it generally be cash. However, I think this simple approach does not adequately consider your overall financial goals, your individual financial situation and the most effective means for creating long term wealth and also providing some security / piece of mind for emergencies.

An Alternative Approach

Each of us has a finite amount of money that is basically allocated between two major categories – expenses and savings. Within each of these major buckets there are a number of sub-categories. So, for example, if I have $100, I can allocate it however I wish amongst these buckets. What is important to remember, however, is that no matter how I distribute the $100 (50/50, 80/20, etc) – it still only adds up to my original $100.

I mention this because it is important as it relates to the discussion of emergency funds and is something I think people often miss when considering how to resource their emergency fund.

For gathering resources to create funds for an “emergency”, I suggest the following, alternative approach:

  • Do not allocate any monies to a specific / separate “emergency fund” until you fully fund your tax-advantaged retirement accounts first (even then, you may choose never to create an “emergency fund” in favor of other investments – but if you are set on it, don’t do it until you do the above first!)

All things being equal, your first priority should be trying to develop a comprehensive plan for creating wealth. For most of us, that typically involves saving some of what we earn in a handful of investment vehicles, namely:

  • 401(k) / Traditional IRAs
  • Roth 401(k) / IRAs
  • Taxable Accounts

The first two types of accounts are “special” in that they provide tax and other advantages that are not typically enjoyed by other types of accounts:

Traditional 401(k) / IRA
– tax benefits on today’s income (reduce your current taxable income by your contributions up to a certain limit)
– employer match (varies) on your contributions to 401(k)

Roth 401(k) / IRA
– future retirement withdrawals (contributions and earnings) are tax-free
– employer match (varies) on your contributions to Roth 401(k) – but match is made in your regular 401(k) (will be taxed upon withdrawal)

Until I FULLY fund these accounts, I am losing the tax and other advantages (ex: company match) these accounts provide that can not be easily duplicated anywhere else and are a proven path to creating wealth. Further, once I have missed the contribution “window” for a given year, once it’s gone, IT’S GONE, I can never “go back” and fund it later…even if I have the money to do so.

  • Until your retirement accounts are fully funded, you should leverage your other options (other than cash) to fund any emergencies
  • Revolving Credit
  • Home Equity – line of credit or loan
  • 401(k) – loan or withdrawal
  • Roth IRA – contributions
  • Traditional IRA – withdrawal
  • Personal loan
  • Of course, not all of these are created equal. For example, making an early withdrawal from your 401(k) is probably a worse option than making a tax / penalty free withdrawal from your Roth IRA. Further, some options may not be available to you (ex: no home equity loan if you don’t yet own a house or possibly a 401(k) loan if you lose your job).

    Many people will characterize these alternative funding options as less appealing than “cold hard cash” with arguments such as:

    • You should never take money out of your retirement accounts
    • Using credit card debt will only make your financial problems worse
    • Taking out a loan costs you interest

    What these arguments fail to address is that to create the “cash” fund for emergencies, they had to make sacrifices somewhere else (ex: putting less money toward retirement and not taking full advantage of the unique benefits your tax-advantaged accounts offer you).

    Also, referring to my earlier comment about the $100, why is putting the entire $100 in my retirement accounts a WORSE choice than splitting it 50/50 or some other way and funding a cash emergency fund? It’s still $100…wherever it went and wherever it comes from if I need it. My suggestion is that by funding your retirement accounts first, you have a better chance at achieving your overall goals AND still making sure you have adequate protection in an emergency.

    In particular, if you are concerned about liquidity, then fund your Roth IRA where you can take out contributions tax-free and without penalty if needed. My point is that you still only had $100 to spend and if you need some of it for an emergency, I see no difference whether you take it out of some cash account with no tax-advantages and the potential for lower long term returns versus the Roth IRA. The kicker is that you may NEVER NEED IT. Emergencies by definition are unexpected and mostly RARE. As long as you are committed to saving the full $100 (versus spending it)…then it will always be there, no matter the investment vehicle / account you decide to keep it in.

    Now, don’t get me wrong…there are some risks involved with this strategy. Also, again, each of the alternative funding options are not created equal. I will talk about those in some more detail in an upcoming “Part 2” posting on this topic.

    “Emergency” Funds – An Alternative Approach – Part 2


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    […] Do I Need An Emergency Fund? (Part 1) […]

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