I mentioned in my Income and Expenses for July that I have a high deductible insurance for my home. Hindsight is always 20/20, and I would have fared better this first year getting a lower deductible, but I will work the math out later to see how it compares in the long run. However, having to shell out $5,000 in cash brings up the important topic of Emergency Funds.
I have referred to needing an emergency fund, but I haven’t yet talked about this topic on the blog yet. When I read financial articles about emergency funds they seem to be this nicely wrapped up basket of money that sits around in a savings account waiting for your call. I am not going to sit around and say the typical advice that you need 3 to 6 months of savings, because every situation is different. If you have multiple streams of income, very low expenses, and no debt why would you really need that much just sitting in cash? Besides, why would you want this money only sitting in, at worst a savings account, or at best a 3% interesting checking account? But really, what is the “3 to 6 months savings” based on? Your income? Your expenses?
Although the reference to layers makes me think of Shrek explaining to donkey that Ogres are like onions in that they have layers, it kind of can work for emergency funds as well. Your outer layer can fend off scary situations being in cash, that quick instant liquidity in time of need. But inside, you are more mature and developed than what can be seen on the outside. You may utilize a Health Savings Account, Brokerage Accounts, and ROTH IRA’s to expand your emergency fund if needed. If you don’t like onions then maybe you could go with a layered lasagna instead. Just picture whatever layered food will keep you interested enough to continue reading.
Layer 1: Cash
Cash is a key in the emergency fund process. My goal is to have enough cash to cover almost any conceivable event. Such as paying out $5,000 in a deductible. My old neon collapsing from the rough winters in Michigan, and needing to get a decent used car. Whatever kind of outlay you consider to be your highest in a short period of time. I personally desire to have about $6,000 to $7,000 in cash at the end of the month. One reason is the beginning of the month pulls out a decent amount of cash between the mortgage payment and student loan payment. So really that end of month balance is basically $1,000 less the next day. So this balance would keep me with a solid $5,000 to $6,000 ready for any sort of catastrophe. This amount may not be the best amount for yourself. You need to decide how much you want to have in cash. Both my wife and I work, so we would likely still have income if one of us lost a job. You may not have the same scenario so you may have a greater need for cash.
Layer 2: Health Savings Account (HSA)
Once you have built up a balance in a Health Savings Account you have one area in which you will probably not experience significant financial risk for awhile. However, while you are building this fund you would be wise to realize that cash may be required to cover the shortfall between your deductible and your HSA balance. I am still accumulating my HSA balance so I probably should add a cushion into my cash pile until this has grown. The bad thing about HSA’s are that you are capped annually to how much you can contribute, currently $3,300 for an individual and $6,550 for a family. The plans maximum out of pocket costs also exceed what you can contribute within a single year depending on your specific plan. So for myself, I probably should keep a bit more cash knowing this, but I am being an optimist and not planning on getting hurt at least until next year when I can fund more into my HSA. I can say this somewhat reasonably… I have never had stitches and the last time I have been to a doctor’s office was just over 6 years ago. I have contemplated that I should start doing my annual checkup though, maybe I should make it a goal for next year?
Layer 3: Brokerage Account
This layer is sort of a mixed bag. On one hand your brokerage account can produce income through dividends or interest allowing you to need less income. It would probably be unlikely with having a solid amount of cash you will have to dip into the capital, but it is possible to have a few bad events in a row depleting your cash fund before you could replenish it. That is why Murphy’s Law was created, right? Either way, it is great to know you could supplement your income now if needed or reach in and grab some money. That is one of the joys of saving that you will have the resources to whether real storms that can become a financial storm. Having a large portfolio could also mean that your need of income replacement is greatly reduced, as your account can create it’s own passive income to help out during a job change.
Layer 4: ROTH IRA Contributions
Let’s be honest, no one really wants to touch their retirement account balances unless if they have to. Although it isn’t pleasant, the one great thing about using the ROTH IRA is that you can take out your contributions tax free. Whereas a traditional IRA or your earnings on the ROTH IRA will be faced with not only taxes, but penalties to withdraw. Having this balance as a backup can help you out in a real bind if all other layers somehow fall through. Although I do not wish to take out any of my contributions as I plan to utilize a ROTH IRA ladder, it is nice to feel secure in knowing that I can access this money if needed.
Optional Toppings (on your Lasagna or Onion?)
I say these are optional because not everyone can utilize them. You could get a home equity line of credit to access credit built in your home at a low interest rate rather than taking away from investment accounts. These equity lines are subject to the whims of your financial institution and many people are debt adverse so they would not like this option. Further some people do not own a home or do not have over 20% equity currently to be able to utilize this resource.
Another layer of protection can be if you have a 457(b) retirement account. These accounts operate much like a 401(k) except one key difference is that at separation of employment you can take money out without penalty. That can be a huge resource for money in the event of a job loss.
What about you, how do you build your lasagna or onion of an emergency fund?
Photo Credit: SOMMAI / FreeDigitalPhotos.net
We have an HSA at work, do that is nice. But more to your point, we also have layers. I keep enough in checking to cover deductibles. After that, I have about 3 months of dire emergency funds (food and shelter) in a money market, for easy access.
If life got super rough, after that, we’d have no other options but our 401k. But for us and our huge debt load, that’s ok. I’d rather bring using spare change (cause that’s all the “extra” we have) to pay down debt.
Hey Kirsten, thanks for stopping by!
Yea you do need some sort of basic level of cash and then a backstop for other expenses. Yes, you can always take out of an IRA (maybe not a 401(k) unless if you lost your job, depends on the plan) if life dealt you a huge blow. The crappy thing is you will likely be penalized unless if you meet one of the exemptions.
Our strategy is similar to yours. We always have the cash on hand but we have a HSA too. I like being prepared for emergencies and we also have a high deductible plan.
Yea I think it is a pretty solid plan. Cash not invested doesn’t bode well for future returns, but it is necessary to have some in my opinion. HSA’s are a great way to build up against medical emergencies, but as I mentioned while you are growing the fund you may want a little extra cash just in case.
Great post Kipp. We have a bunch of different “funds” that we can tap into in an emergency, but I like to keep our “cash” fund large enough so that we would never have to dip into any kind of retirement savings. Our taxable brokerage accounts obviously aren’t off limits, but if you manage to keep your expenses low and a decent chunk of cash on hand, even with a $6000 emergency, you shouldn’t have a fund that is depleted for more than a few months, while you work on building it up.
Hey Ryan,
That is very true. Although you may Fear on Missing Out on the compounding while you are replenishing that cash supply! (see what I did there?)
But it is nice to have those account as options in case you get hit again before those couple of months to replenish your cash stash.
I keep mine in cash (high interest savings account) and I also have a Roth just in case I need some extra cash.
Good idea Aldo. I like the ROTH as a backup layer, but I would probably reach into a brokerage accounts first.
I like the Onion comparison and not to be confused with the hilariously funny paper named “The Onion” of course. I like to think of it as what would I do if ish really hit the fan, where would I go. Cash/Savings, Stock, Loan of some sort, Retirement account, in about that order. And additional toppings can be on an onion don’t short yourself, you can bread it, fry it, ok I don’t really know but I’m not hungry for onion rings, thanks.
As long as onion rings are in your budget or you will receive a large amount of happiness in their consumption, have at it! Yea I did hint towards loans in the toppings by referring to an Equity line of credit. You could also defer costs on credit cards, but you don’t want to end up paying that interest. You may have different loans available, but usually interest rates aren’t the best unless if you have it secured somehow.
My layered food would be a Gobstopper, because yay sugar. My actual emergency fund is similar – I keep about three months of expenses in a plain jane savings account, have an HSA (which is drained now, need to build it back up), and then we have a taxable investment account if it really hits the fan. Then we have our 401ks of course, but would hopefully have things turned around before it got to that point!
Hey Autumn. Yea I think after you get a certain amount of expenses saved, say 2-3 months, maybe having those funds growing isn’t a bad thing. Long-term it should pay off better, unless if the emergency struck right after investing and the markets took a bit of a drop (or a dive). You never know when that might be so your next best guess could be averaging in.
Nice touch with the onion comparison Kipp. For us it’s mostly cash and an HSA. Of course their are other things, but we’d avoid those at all cost. I am envious if you’re getting anywhere near 3% in a savings account though. I’ve seen such rates for very small balances, like up to $3000, but nothing for real money.
-Bryan
Thank you Bryan. The 3% works for upto $15,000. Check it out, I would recommend it if you don’t mind banking online (no affiliate link here, just earning decent interest for years
)
I’m currently building an emergency fund. I think it’s really important, you never know what unforeseen expenses can quickly pop up. It’s just difficult having cash sitting there and not earning anything.
But slowly stashing cash away every month helps. Slow and steady works best for me.
Great post as always, cheers.
Hey Henry. It is difficult to have cash laying around, but it is helpful as well. I am kind of over extending myself just a little so I need to chill out until December or so before I start putting more in ROTH’s again. I just want that loan gone! Then I went and bought $1,000 in AT&T. Oh well, much better than living paycheck to paycheck.
Kipp,
I literally have no idea what all the abbreviations and special accounts mean, but I like the onion comparison!
My emergency fund is too big at the moment and it’s in a savings account, so that’s something I have to work on. I also have another account (special Belgian insured account) from which I can withdraw almost twice the amount of my savings account without penalty.
As such, I’m not sure what to do with my emergency fund. There aren’t as many options as you mentioned above in Belgium, but it’s kind of sad to see inflation eat away at my emergency fund. On top of that there are hardly any unexpected expenses I can run into: health is covered by the state and work, I don’t have a car, I rent my house, I don’t have expensive stuff that needs instant replacement, I can’t lose my job (or I’d have to try really hard), and I live on less than 50% of my monthly income!
I’m actually quite risk averse, but at this point in my life there is hardly any financial risk at all to not having an emergency fund… Decisions, decisions!
Cheers,
NMW
Hey NMW,
Well, being your not in America, not sure if you are interested, but here is a quick overview:
Health Savings Account (HSA) – You can put in money pretax and use it tax free for health expenses.
ROTH Individual Retirement Account (ROTH IRA) – This is money that is saved in a retirement account after tax, but grows tax free. In America retirement accounts are penalized 10% if taken out before age 59 1/2, but your contribution to a ROTH are not subject to this penalty.
457(b) & 401(k) – Both Pretax retirement accounts that grow tax deferred in which you can normally only withdraw after 59 1/2 without penalty (but there are a few methods of getting some out earlier without penalty, the method I will utilize is converting to ROTH accounts)
Sounds like a good deal with the special insured account. Is that a fixed amount or always just 2x your savings account?
Thanks for the explanation! We don’t have any of the accounts you mentioned… Especially the HSA sounds weird to me.
The insured account is actually contract-based and at the time I put in some money the contract stated that a 3.15% interest rate is applied to those payments until the contract was dissolved (which both parties need to consent to).
It’s just coincidence that it’s now double my emergency fund. I don’t contribute to that account anymore because for future payments the interest rate is set to 0% because the European Commission deemed them too risky for the insurance company.
I would imagine you have some sort of retirement account system in which gives some sort of tax benefit? No way to defer taxes at all? The HSA is a good account but not all health plans are eligible to have one and the crazy thing is you can even invest the money in a HSA! The thing is it is ONLY for medical expenses. At age 65 you CAN take the money out without penalty, but then it acts much like a tax deferred account instead. I haven’t looked into investing options for the HSA yet as I am still building the balance, so just a low interest account for now.
Interesting deal with the bank. So you have money inside of it earning 3.15% interest that the bank cannot change unless if you agree to it? Not a bad emergency fund. I have mine in a checking account that give 3% but there are a few requirements I need to meet each month to get it.
There are only two special types of accounts that offer a tax break, but they’re mostly supplements to your pension. We don’t have tax deffered accounts because everyone who was employed at some time is eligible for a pension provided for by the state. The really weird thing is that we don’t have capital gains taxes, so tax deffered accounts don’t make as much sense anyway.
Yup, the bank can not change the interest rate because it’s contract-based. Best deal ever basically if you don’t like taking risk.
3% is pretty sweet, even with the monthly requirements. Especially because it’s risk-free!
Ok, no capital gain taxes basically trumps all of our accounts. I guess the closest thing we have is a ROTH account because we contribute with after tax dollars but pay nothing on earning or dividends in the account. But we have contribution limits on these, right now at $5,500 per year per person (so being married, my wife and I can do $11,000). You can do a little more if you are older, I think age 55 and up.
We are not there yet, but definitely will consider some layers when building our e-fund. I prefer the seven layer dip comparison.
Hey, whatever food floats your boat! 7-layer dip sounds yummy, but I am not sure if my emergency fund will have 7 layers for a good comparison :).
Great post! I really think the concept of having an 6 to 12 months of emergency funds in a savings account is kind of antiquated. I’ve never thought of it in terms of “layers” but you’re absolutely right. Keeping too much in cash in this low interest rate environment is not ideal. I don’t have access to an HSA, and while I wouldn’t want to touch my IRA…it’s good to know I have the option if there was a true emergency.
Thanks Andrew! Yea I think it is nice to have 6-12 months AVAILABLE between all of the layers, but maybe not necessarily all in cash.
It is unfortunate that a HSA isn’t available for everyone. I really do not see why because most plans that have a lower deductible have co-insurance which still reaches the same limits of alot of HSA plans. I think it would serve us better if they just allowed everyone access to the plan.
I have $5000 in cash, another probably $5000 I could liquidate if need be. I don’t have high insurance premiums (car and content are both $1,000 so they’d be covered), and great health insurance through work (no concern about high deductible, especially here in Canada). I have life insurance, critical care insurance and disability insurance, so I feel like I could get by most things thrown at me. If I ran out of money before the emergency was gone, I have a LOC. And if I tapped that out (it would be one hell of an emergency!! Or a perfect storm of multiple smaller ones) I would begrudgingly ask my parents for a temporary loan.
That said, I don’t feel like I have enough of a nest egg, and I want my debt gone with more money in the bank should stuff really hit the fan. At the moment, debt repayment wins.
That sounds like a great system! Yea I wish our health system was better than our military system… maybe I should move across the border, I could even be a little bit more south if I stayed around Windsor area! Looks like Hamilton is more parallel with where I am at though :).
Nice strategy! I’m a big fan of putting structures like this in place. That way you can maximize your returns while still having liquid assets and not having to park all your money in a low interest account.
Thanks MMD. Yea you need some cash, but the question is how much do you really need? A base level that works for you can then still some other funds that are liquid if needed.
I’m so glad you mentioned the HSA! I feel like only 2% of personal finance bloggers write about it, but it’s been a HUGE lifesaver for my wife and me as the past three years at least one of us has had surgery (totally unavoidable surgery that can happen to even perfectly healthy people). I plan on contributing the max as long as I have an HSA. It doubles as a retirement account too!
Hey DC,
I can see why some personal finance bloggers don’t mention it, because it is not available to everyone. But it is the best way to pay for medical costs if you have it! I honestly think they should just allow everyone to have a HSA, your co-insurance on a non-high-deductible plan is usually astronomically high anyways.
And yes, doubling as a retirement account, but at age 65, not the usual 59 1/2. And no backdoor to get out earlier without very harsh penalties to my knowledge.
Hmmm interesting, I didn’t know about HSA. What an interesting concept. Really enjoyed your post on how there are different layers to an emergency fund.
Thanks Tawcan! Yea that are a great way to put aside money if you are eligible!
This was an interesting post. I don’t have that much saved up in my EF yet, but ideally I’d like to get to a point where I had a year’s expenses (that’s a $12,000 bare bones budget, or, if I wanted to keep up my current lifestyle, about $35,000) available with relatively little hassle and without getting into my retirement accounts.
And…I sort of do. Because I have that much available on my credit cards. Oof. Right now, they really are my “e-fund,” which, yes, is scary. I want a real e-fund built up so that I don’t end up having to make that choice! It’s not so easy to do on a teacher’s salary, so I guess I’m just hoping emergencies hold off until I can get a little more saving done.
In my ideal world, I’d have $2000 in straight cash, $6000 in a CD ladder, and $25,000 in a taxable brokerage account, I guess. I worry about that last, because what if the market crashes right when I need it, but I really don’t like the idea of my (entirely theoretical!) year’s worth of expenses earning less than 1% interest. It’s depressing.
I wouldn’t worry too much about the money being in a brokerage account for the long term. With $8,000 in your first two layers in probably wouldn’t be any time soon that you would not have to touch the brokerage account. That beings said, in it is in there long term it is unlikely to lose money over say a 10 year period even right after a market crash. I wouldn’t say it is impossible, but it isn’t very likely.
And yes 1% interest is depressing.
Great post. I like your layer approach. When I was 40 I decided a year’s worth of mortgage payments was the ideal emergency fund amount as I figured I could pay the rest of our essential expenses with unemployment payments or other ways if I had to. For us then it meant $12K which we dug in, cut spending waste and dedicated $500 a month to a Money Market Fund. Once $12K was achieved I just contributed the $500 a month to Roth IRAs for the Bride and I knowing it was available in a worst case scenario as you pointed out. I never had to hit the emergency fund and since retiring early at age 51 I now just keep $10K in an emergency fund at a credit union savings account. Even though it is dead money as far as earnings, it is readily available. I hope I never have to hit it either.
Prost!
Hi Tommy,
Wow $500 a month cut out, that is impressive! Great job not bringing back those lifestyle costs and continuing to save it! If I were to take that same approach I would have $9,600 needed for emergency fund. Which cash wise I plan on being fairly close, around mid $6,000’s. So once my brokerage account grows a bit more I will be there.
Age 51 is a great time to retire! I have went through and crunched my numbers and plan on getting a post together for that. It looks like I could “retire” at 43, but I would want to maybe get a little more income in or work part time to get together money for traveling. But as long as all of my basic needs (plus a few luxuries) are covered, I would be financially independent which is pretty exciting to think about.
My wife and I think in terms of time. Our net worth is our emergency fund, it just matters how quickly we can utilize it.
We have cash reserves at our credit union for a few months or sudden large expense. We have stocks, p2p lending, helocs and 401k loans for past 6 months, and we can sell real estate if we need to move past several years.
The nice thing part is those funds are based off today’s spending. We have a list of items we can cut at any time to extend our reserves.
Jason
Hi Jason,
It sounds like you have a very good plan in case if things go south. Interesting you consider your entire net worth your emergency fund, but I suppose it makes sense. There are usually a few things you will keep like a house but if it came down to it, most of us could downsize if need be or find other things that we could sell.
Great that you know where you can cut down on spending as well!
Kipp
I like that you included your Roth IRA in your EF, so few people do but I think it is an important part of one.
Thanks Ginger, I feel that it is important to consider all available funds in case of a dire emergency.