You can’t predict financial emergencies – but you can prepare for them.
To do that, you can build an emergency fund to pay for unexpected expenses, some of which may be sizable. Without one, you might be forced to dip into your investments, possibly including your retirement accounts, such as your IRA or 401(k).
If this happens, you might have to pay taxes and penalties, and you’d be withdrawing dollars that could otherwise be growing over time to help pay for your retirement.
In thinking about such a fund, consider these questions:
• How much should I save? The size of your emergency fund should be based on several factors, including your income, your spouse’s income and your cost of living. However, for most people in their working years, three to six months of total expenses is adequate.
Once you’re retired, though, you may want to keep up to a year’s worth of expenses in your emergency fund because you don’t want to be forced to cash out investments when their price may be down and you might not be replenishing these accounts any longer.
• How can I build an emergency fund? Given all your normal expenses – mortgage, utilities, food, transportation and others – you might find it challenging to set aside some extra money in an emergency fund. But you do have opportunities.
If you’re working, you could set up a direct deposit so that part of your paycheck goes directly into your emergency fund. You could also save a portion of any extra income you receive, such as bonuses and tax refunds.
• Where should I keep the money? An emergency fund has two key requirements: You need to be able to access the money immediately and you need to count on a certain amount being available. So, it’s a good idea to keep your emergency fund in a liquid, low-risk account that offers protection of principal.
For this fund, you’re less interested in growth than you are in stability. But because interest rates have recently changed, you may be able to get a reasonable return without sacrificing liquidity or safety.
• What types of emergencies should I prepare for? Your emergency fund could be needed for any number of events: a job loss or early retirement, housing or auto repairs, unreimbursed medical bills, unexpected travel and so on. But this fund may also be needed to help you cope with other threats.
Consider this: In 2023, the U.S. saw a record 28 weather and climate disasters, each of which resulted in at least $1 billion in damages – and often many times this amount – the National Oceanic and Atmospheric Administration reports. Depending on where you live, your home or business may be susceptible to tornadoes, floods, wildfires, hurricanes and extreme heat and cold waves. These events can and do result in property repair and relocation costs, higher insurance premiums and even price increases for basic goods, such as groceries and prescription medications.
One final word about an emergency fund: It takes discipline to maintain it and to avoid tapping into it for everyday expenses or impulse purchases. The name says it all – this is a fund that should only be used for emergencies. By keeping it intact until it’s truly needed, you can help yourself weather many of the storms that may come your way.