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How Much of an Emergency Fund Do You Need?


 

From Citi Personal Wealth Management

How much should you set aside for a financial emergency? Whether it's in case you lose your job, need to replace the furnace or have an unexpected car repair, your goal is to make sure you're covered without going overboard.

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. But 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.

In addition to tapping taxable accounts for a source of funds in the event of an emergency, other options to consider include:

• Borrowing against a life insurance policy's cash value. Be aware that if you don't repay the loan—plus the interest charged—your policy's cash value and its death benefit will decline. 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 If the total amount withdrawn exceeds the premiums paid for the policy, the excess would be taxable.

• Borrowing from your 401(k) plan. This option may involve some financial risk. If you can't repay your 401(k) loan, it may be considered a distribution, possibly triggering income taxes and probably a 10% tax penalty. 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.

• Funding a Roth IRA. You can save for retirement and build up an emergency reserve at the same time. Suppose you contribute $5,000 in a Roth IRA 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 IRA 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 IRA offers 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, including.

- Aiming 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, vacations, eating out 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.

- 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. But be warned: If you have an insurance claim, your out-of-pocket cost will likely be greater.

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Investments are subject to market fluctuation, investment risk, and possible loss of principal.

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