Emergency Funds: Crucial

You can save for retirement and chip away at debt. But you neglect to build a cash emergency fund at your peril. While cash doesn’t yield returns, it provides you with a crucial safety net.

Many investors, even very savvy ones, are asset rich and cash poor. To them, compared with paying down a mortgage at 4% or earning 10% in a mutual fund, having cash sit in the bank just isn’t an attractive idea.

Yes, savings accounts offer next to nothing – usually a fraction of 1% annual returns. Thanks to inflation, savings in the bank actually decreases in value. So why not put every penny of your savings into higher-growth or tax-advantaged accounts? 

For example, I recently met with a very responsible couple to work on a financial plan. They contribute 15% of their wages to long-term retirement, regularly contribute to Roth individual retirement accounts, have no debt other than a mortgage and can pay a college tuition bill within their cash flow and. But they didn’t have an adequate amount on hand for short-term emergencies and cash needs.

Their mistake is trying to be as efficient as possible with their investments. Unlike most of your other financial priorities, holding cash is never the most efficient thing to do and its importance is often overlooked. The couple put every available dollar toward their retirement plan or into paying down their long-term mortgage debt.

On the surface, this couple seems very financially healthy, but what if one of them lost a job? Especially after the recent downturn, this is an obvious danger for even the best workers. Or what if they have to pay another tuition bill or an unexpected medical expense? What if they suddenly need a new car?

Because they neglected to save some cash, their only choices are bad ones. If any of those short-term emergencies occur, they have no option other than to go into debt or raid a retirement fund.

For instance, if they opt to take a withdrawal from their Roth IRA before they reach age 59½, they get hit with a 10% penalty on the earnings in the account. Also, the distribution is not tax-free, as it is after age 59½. Even though they probably have good credit and can borrow to meet the emergency, they probably can’t find a better annual percentage rate lower than 10%. In this case, losing a small amount every year to inflation doesn’t sound as bad.  

An emergency cash reserve protects you from the need to sabotage your long-term investment plan, or take on high interest debt to cover cash needs. Even at the expense of not fully funding a retirement account or paying extra on a student loan now, it’s smart to have at least three months of your net income in a cash account.

Three months is a bare minimum. If you are self-employed, have rental properties or other issues that can destabilize your income stream, you need at least six months of income in cash.

Make having emergency cash in a savings account or money market a priority now, and when a time of need comes, you have less to worry about.

 

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Robert Schmansky is a financial at Clear Financial Advisors LLC in Royal Oak, Mich. Website: www.clearfinancial.net

The preceding content was originally published on the Financial Planning Association website, http://blog.fpaforfinancialplanning.org/2013/02/14/emergency-cash-reserves-unloved-yet-necessary/

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