In life, we should expect the unexpected — and be prepared to handle emergencies both big and small. Having an emergency fund is an essential part of good financial planning. With three to six months of living expenses in a separate savings account, you can be ready to handle most emergencies, without resorting to high interest credit cards or personal loans to cover bills.
While most people are aware that they should have an emergency fund, they may be confused about how to manage this money. Being smart in creating an emergency fund can help you build your total net worth — and increase your financial stability.
There are many myths out there about how to best set up and handle an emergency fund. This article explains why each of these myths are false — and what you should be doing with your emergency fund instead.
Myth: Put As Much As Possible Into Your Emergency Fund
An emergency fund should contain approximately three to six months of basic living expenses. Anything above that amount represents a wasted opportunity to use your money in a better way, such as through investments with a far better return for your money.
Savings accounts typically have very low interest rates of 1 percent or even lower. Money stashed in a savings account may be safe — but it won’t help you increase your net worth. By contrast, a high yield savings account may have an interest rate of 7 percent — a much higher rate of return. If you put your money into a high yield savings account or another investment vehicle, that money will ultimately earn far more for you over time.
While it is important to have a certain amount set aside for emergencies, having too much set aside is counterproductive. The best bet is to only keep what you need in an emergency account — and put the rest into a higher interest investment account. This strategy will ensure that your emergency fund is intact while your other money is working for you.
Myth: My Emergency Fund Should Be Set At My Current Level of Spending
Most people have monthly living expenses that would likely be considered luxuries: a trip to Starbucks, lunch out, or new clothes or shoes. When building your emergency fund, it is not necessary to include these expenses in reserve. Instead, focus on your core expenses — the payments that must be made, no matter what. This could include mortgage payments, student loans, car payments, child care expenses and utilities. It should not include discretionary spending like vacations or going out to eat. If an emergency arises, you can cut back on these unnecessary expenses and live on a more limited budget to avoid going into debt.
This goes hand in hand with the first principle: you should only have what you need in your emergency fund. Instead of including money for non-essential items in your emergency fund, you can put that money to work for you in a higher interest account to maximize your net worth.
Myth: An Emergency Fund Should Be Put In Investments
After being advised to only save the minimum amount in an emergency fund so you can invest your money, you may believe that it is a good idea to invest your emergency fund. But an emergency fund has a different purpose than investment accounts — and it should be kept both separate from investments and easily accessible.
Typically, investment accounts require you to keep your money in place for a certain period of time. If you withdraw money early, you will lose money either through penalties or from the lost investment opportunity. And if the market crashes — as it did in 2008 — then you could lose the value of your emergency fund, in addition to any growth on the money.
When you need to tap into your emergency fund, you should be able to do so without penalty. Emergency funds need to be easily accessible so that you can actually use your money in an emergency — without any penalties or loss of growth potential on your investment.
Myth: I Can Use My Retirement Fund For Emergencies Once I Reach The Right Age
Once you reach age 59.5, you can withdraw from your retirement account without the 10 percent tax penalty for early withdrawals. Some people may assume that because they are over this age, it makes sense to use a 401(k) or other retirement account as an emergency fund. But there are still negative tax consequences to withdrawing money from your retirement account, which is why using this account as an emergency fund is not a smart strategy.
When you withdraw money from a pre-tax retirement account, the money that you take out is treated as income. Not only will you have to pay taxes on this money, but the additional income may put you in a higher tax bracket — resulting in a pretty big financial loss if you have to pay significantly more taxes.
The better plan is to put money aside in a separate account just for emergencies. That way, you won’t have to dip into your retirement account if an emergency arises and you won’t be hit with additional taxes.
Myth: I Should Avoid Using My Emergency Fund
Emergency funds exist to be used. While you should not use it for frivolous expenditures, like a vacation, if you are faced with either using these funds or going into credit card debt, it is usually smarter to use your emergency fund.
There are many situations that arise where it may be necessary to pull money from your emergency fund. Perhaps your hot water tank broke, or your car broke down and needs an expensive new part. While these aren’t emergencies in the sense that they are life or death, they are “emergencies” if you cannot afford to pay for the tank to be replaced or your car to be repaired without going into debt. The key here is to carefully analyze how you used your emergency fund each year, and to review your budget accordingly. If you are dipping into your emergency fund frequently, consider where you might make cuts in your spending so that you can more easily afford these expenses.