Emergency Fund Planning

Emergency Fund Planning

Preparing for unseen contingencies is an essential element of financial planning. Having an emergency fund allows you to address an unexpected need without forcing you to abruptly sell long-term investments in suboptimal conditions. Being forced to withdraw funds from accounts such as retirement accounts that are not intended for emergency use can also lead to unnecessary taxes and penalties. It is best to plan ahead for such contingencies and have an emergency fund ready for use.

Liquidity

An emergency fund should consist of liquid assets that can be readily accessed at their fair market value which is not subject to significant price fluctuations. An emergency fund is not used for everyday transactions, so it should be help in accounts that earn a reasonable short-term interest rate. This includes high yield savings accounts, short-term CDs, money market funds, and short-term bonds.

Another source of emergency funds can be borrowing from appropriate assets. This includes:

• Borrowing from the cash value of a whole life insurance policy. This should be avoided if there is a need for the full death benefit since any outstanding loan balance will reduce the death benefit.
• Borrowing from a 401(k) or similar retirement plan. However, loss of employment would make the loan immediately payable or risk it being treated as a taxable withdrawal instead.
• Borrowing from a reverse mortgage line of credit. Retirees can use the line of credit feature of a reverse mortgage to tap into their home equity in an emergency.

Taking Action

The general recommendation is to have 3-6 months of expenses saved in an emergency fund. A household with multiple sources of income can afford to have a smaller emergency fund. If you are more at risk of longer periods of income disruptions or larger contingency expenses, you should save a larger amount. Such circumstances include:

• Relying on a single income.
• Receiving income in uneven amounts at unpredictable times.
• Having less health and disability insurance coverage.

People with especially volatile incomes might want to set aside up to a year's worth of expenses. However, keeping more than a year of expenses in an emergency fund should be reevaluated since tying up so much money in short-term investments could harm long-term prospects. In such cases, other options such as additional insurance might be more appropriate.

Whenever your emergency fund is below the desired level, it is a good idea to automate saving to fill it back up as soon as possible to be ready to avoid the next crisis. Setting aside a certain amount from each paycheck makes it easy and relatively painless. Automation can be crucial in getting it done.