Determining an appropriate emergency fund


What is the size of an emergency fund a future retiree should have?  Why set one up at all?  How should an emergency fund be compiled?  Before we answer these important questions, I think we should define what an emergency fund is.

According to Investopedia,

An emergency fund is an account used to set aside funds needed in the event of a personal financial dilemma, such as the loss of a job, a debilitating illness or a major expense.

Why have an emergency fund?

Many financial planners advise a 3-6 month emergency fund.  Let’s explore some reasons why you might want to have emergency funds.

If you have emergency funds, you might be able to avoid these long lines when out of work.
  1. Unemployment–  This is the number one reason to have emergency funds.  This is a valid concern and happens to most people, at one time or another, in a career. I think it is important to have some sort of liquid assets set aside to prepare for such an event.
  2. Housing repairs–  If you own a house, you are your own landlord.  Any big-ticket expense that needs repair in your house falls solely on your shoulders.  You may not have control over when these expenses might be incurred.  For example, last summer our AC unit’s coil failed.  While it seemed as if most HVAC contractors wanted to sell us a new unit, it was obvious that repairing this coil would be much cheaper, and make the AC unit last much longer.  After a few phone calls and quotes, we were able to have our AC unit coil replaced for around $2,000.
  3. Car repairs–  If you drive an older car, or drive a lot, it’s almost inevitable that you will run into minor car repairs.  Minor repairs, such as brake work, can generally be funded through normal work income.  However, major repairs such as rebuilding a transmission or engine can cost 2k-3k per item.  While I am a big advocate for DIY repairs, as your skill level and YouTube videos allow you to do, most people won’t have the tools or knowledge to take on the largest of automobile repairs.  For example, in 2012 we had our transmission rebuilt on our 2001 Acura CL.  We received multiple quotes, and the best price was given by a local transmission shop in town, which had great reviews.  Regardless, this major repair still cost us over $2600.  Luckily, we had plenty of funds on hand to cover this.
  4. Health care expenses–  If you get injured or have a baby, it is likely you may have a large expenses under a high deductible health insurance plan.  In addition to meeting a high deductible (2k or more), you may need to pay a co pay. These fees add up.  Good news is, if you are expecting a baby, you may have 9 months to save for this expense.  For a serious injury, you may not have such a luxury.
  5. Avoiding debt–  Any emergency fund’s goal is to pay for things while avoiding going into debt.  The worst kind of high interest debt is credit card debt.  Therefore, setting up an emergency fund will help you avoid paying exorbitant, wealth destroying, credit card interest.

How much emergency funds should you have?

For a 6 month, worst-case scenario bout of unemployment, you generally should have 6 months of living expenses on hand.  This should not be confused with having 6 months of income on hand.  If you are frugal and a saver, you will have surplus funds being poured into your investments each month.  Therefore, you can ignore these amounts when planning your emergency fund.

Let’s look at an example.  Jill takes home $3,000 per month from her day job.  She is 29 years old, has roommates, and lives frugally.    Let’s look at her expenses:

Rent                     500
Netflix                   10
Utilities                100
Cell                         30
Food                     400
Car Insurance        75
Entertainment     150
Restaurants         100
Salon                      50
Clothes                   50
Gasoline               100
Investments      1000                                                                                                                         Monthly Surplus 435

Upon reviewing these expenses, it’s safe to say that we can eliminate the investments and monthly surplus as actual expenses.  Deducting these two out, we can estimate she has expenses of (3000-1435) $1,565 per month.  So simple math would tell us, for six months of emergency funds, she should have $1565*6=  $9,390 in savings.  Or should she?

If you are looking for a job and have no work income, you need to cut out unnecessary expenses.  This isn’t negotiable.  You have a real emergency and even your small discretionary expenditures should be eliminated.  Having said that, let’s see what we can cut out of Jill’s lofty budget.

Entertainment-  150, Restaurants-  100, Salon- 25 (now every other month), Gasoline- 50 (slash in half; no work commuting, no frivolous driving).  These reductions total an additional $325.  We can now say that her adjusted emergency budget is down to (1565-325) $1240 per month.  As we re-do her emergency fund math, we now see that her goal emergency fund should be $1240*6=  $7,440.

Where to fund your emergency fund?

Don’t keep your emergency funds here, or in savings

I would like to brag to you that I have always been a ninja at maximizing our returns and have kept little cash on hand.  Sadly, that is not the case until recent years.  A review of our savings account for cash on hand, stacked away, reveals the following amounts:

12/31/2015-  $8,049                                                                                                                                   12/31/2016-  $5,000                                                                                                                                   03/07/2017-  $5,346

As recently as 2011, when we purchased our last used car, we kept a mind-boggling $20,000 in our joint savings account.  Call the exterminators because this couple had serious dust mites in their savings account.  I, like many, had succumbed to the idea that an emergency fund should be in cash.  As we continued to watch the stock market rally while we sat around with our heads bowed in shame, we decided to adjust our cash on hand to a more reasonable $5,000, and invested the surplus instead.  As stated above, the largest emergency we ever had been under $3,000, although your results may vary.  One could even say that these weren’t even real emergencies, given that we had ample time to plan for them, but I digress.

As recently as 2011, we kept a mind-boggling $20,000 in our joint savings account.  Call the exterminators because the client has a serious dust mite problem in his savings account.

Many financial advisers will suggest you need to keep your emergency funds in cash, like a savings account, or cash equivalents like CD’s.  I am here to free you from those expensive shackles.  Consider yourself released.  These assets, precious cash, are too valuable to be locked up in such low yielding accounts.  These are your future early retirement dollars.  As such, you need to treat them with the care and concern you would provide to an infant.

My definition of where to keep an emergency fund is anywhere you are able to access those funds within 30 days.

Acceptable Emergency Fund Locations

  1. Taxable brokerage account–  These can be set up anywhere.  You can buy a low-cost index fund, like Vanguard Total Stock Market ETF (VTI), at Vanguard.  Vanguard seems to be the most popular place to have a brokerage account in the FIRE community.  However, we keep our money at Capital One Investments as well as Fidelity.  If you buy a low-cost market index fund like VTI, it is easy to sell and have your money in a few days.  If you temporarily charge purchases to a rewards credit card like we do, and pay it off in full each month, you will have at least 30 days to float this money.  The funds from a sale of an ETF, however, will clear within days and can be easily transferred to your linked bank accounts.
  2. Roth IRA–  If you already have one of these with principle in it, and haven’t already withdrawn all the principal like we did, I count this as an emergency fund.  Any principle you have can be pulled out, at any time, free of tax consequences after the account has been set up for five years.  Let’s say you have six months of expenses totaling $20,000.  Next, let’s say you have contributed $15,000 to your Roth IRA over the last five years.  The gap you have is only $5,000.  I would suggest keeping some or all of this difference in cash, if not in a taxable brokerage account.
  3. Savings account or CD’s–  I don’t recommend keeping a lot in these accounts.  Our savings account has a very good yield, yet is only 0.75%.  By keeping cash in our savings account, we aren’t even keeping up with inflation.  However, there is some comfort in having some cash in hand.  Therefore, we keep $5,000 in our cash savings account.  We usually have a slight amount of surplus cash in checking, but we classify this as working capital.  That means our checking cash will eventually be used for our living expenses.  If we have too much in our checking, we transfer those funds into savings.  Alas, if we have too much in savings, we transfer that surplus into our brokerage account to be invested.

Emergency Fund Alternatives and why I don’t freak out about it

In a case of real emergency, such as unemployment, there are many options other than cashing out your investments to fund your living expenses.  Let’s review these:

  1. Interest free credit cards–  It seems periodically I will get an offer for either 12 or 18 months of no interest on a credit card, or a credit card with free balance transfers for 12 months or more.  In the case of a real emergency, a financially disciplined spender should be able to take advantage of these.
  2. Collecting dividends in cash–  While I recommend reinvesting all dividends until FIRE, I do think in the case of an emergency, it’s OK to collect them in cash instead.  If you like, you can have these set up to be deposited directly into your savings account as they are received.  This is a nice way to “buy time” until the emergency is over.
  3. Severance and unemployment benefits In reviewing my work history, I have been laid off 3 times since I graduated college.  My severance paid included 1 week, 3 weeks, to FOUR full weeks (only 8 months employed at that one).  At that time, I was young and didn’t negotiate my severance.  Doing so may have resulted in even more money.  However, even one week of full pay, plus accumulated vacation, felt like an absolute windfall for me.  I was a low spender anyway, so receiving extra weeks of severance plus vacation paid out, well exceeded what I would spend those months.   In addition to severance, I qualified to receive even more vacation pay from the state government, also known as unemployment benefits.  At the time, I received $335 per week, and those funds exceeded my expenses.  Unemployment benefits are also considered “unearned” income, so you pay absolutely ZERO FICA (social security) tax on these funds.  Wow, I felt like a lottery winner each time this happened.  I currently live in a state where unemployment benefits are stingy.  Yet, this stingy benefit still maxes out at $275/week.  Think about that amount, $275 per week is more than residents of Somalia and Burundi earn in an entire year.
  4. Selling used junk-  Let’s admit it, we all have been putting off selling something for a while as work, kids and life got in the way.  In our house we have fantastic used clothes we’d like to sell on E-bay sitting in our laundry room, just waiting for us to list them and cash in on their sale.  In addition, we also have a children’s trailer bicycle that we haven’t used much sitting in our garage.  If you have a real emergency, like unemployment, you now have the time to sell these things on Craigslist or E-bay, and let that emergency cash roll in.

Daily Deals on E-Bay

Final Word

Who needs a gun when you have bullets like these in your nest egg?

In the sometimes confusing world of personal finance, it’s real easy to get slumped into a routine of having a lazy emergency fund.  Don’t be that person.  Let your funds do the hard-work, and only call on them if you have a real emergency.  Increasing the size of your overall nest egg will be the only defense you will ever need against any real world emergencies.

Increasing the size of your overall nest egg will be the only defense you will ever need against any real world emergencies.

Realistically, most financial emergencies are somewhere in the $1-3k range.  In the case of unemployment, the emergency will be greater.  However, as noted above, there is plenty of residual income coming your way if you have been working a job for a while and are laid off.  With historical returns of the S&P 500 (1965-2016) with dividends, at 9.7%, keeping your emergency funds in a cash savings account is simply too costly.  Instead, fund your emergency fund with your Roth Principle or a taxable brokerage account.  Your burgeoning net worth will thank you for this favor and your early retirement dreams will arrive sooner.

How much do you have in your emergency fund?  Where do you keep your emergency fund and why?  

4 comments

  1. Neat strategy with the Roth IRA as an emergency fund. I like it a lot, especiallly with how reasonably liquid it is.

    In terms of other “alternative emrgency funds” I utilized a portion of my 457b for an emergency bail out loan to myself. I still feel good about it since I get to pay the loan back to myself at 4%. Thus, more of my funds go to my account and the small portion has a decent guaranteed interest rate.

    Altogether, I like the alternate plans. Cash in a readily accessible account just wants to be spent. Its a force of nature. Limiting the amount lessens the pressure on you to use.

    1. Thanks for your wise comments. That 457 loan isn’t a bad idea. However, keep in mind that interest you are paying yourself back is actually taxed twice. It is after tax money you are using to pay yourself interest, and then when you withdraw it later on, it will be taxed yet again. Not the end of the world, but a nuance that I read about when I considered a 401k loan a few years back.

  2. I keep my emergency fund in an Ally bank account. I view my emergency fund as insurance against bad things happening. So while it’s tempting to push it into the market if the market fell by 50% I’m a little worried if I’d be scared to pull out the money b/c it was so low.

    Anyway great thoughts and definitely something to consider moving forward.

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