Most financial experts recommend that you have somewhere between three months and six months of basic living expenses in your emergency fund.
The three-month guideline is generally recommended for those who are in salaried positions and have more secure employment. The six-month recommendation is for those who have less stable employment or earn variable incomes.
If you fall into the second category, an income reduction may even be more likely than a complete job loss. An emergency fund can be used to help cover your basic living expenses during a time when your income has been reduced.
Naturally, you’ll need to rebuild your account when your income increases. The basic idea will be to build up the account during high earning months, in preparation for low-income months.
Why you should save?
Having a well-funded emergency fund is more important than just providing funds for a potential disruption of your income. Apart from covering basic living expenses, your emergency fund will do the following:
Prevent you from needing to liquidate retirement accounts
Retirement accounts are the primary investment asset of most people. And for many, it’s their only source of significant savings. For that reason, they may be tempted to tap those funds in an emergency. But doing so invites tax consequences.
At a minimum, you’ll need to pay ordinary income tax on the amount withdrawn. But if you’re under 59 ½, you may also be subject to a 10% early withdrawal penalty.
That may solve a short-term need for cash, but it will create an additional tax liability the following year. A well-stocked emergency fund will prevent that outcome.
Avoid the need to liquidate investments
If you need to sell stocks or funds to raise cash in an emergency, one of two outcomes will be likely:
- You’ll sell those investments at a loss, locking in the loss at the same time, or
- You’ll sell the investments at a gain, creating a capital gains tax liability.
Once again, a well-funded emergency fund will eliminate the need to sell investments in an emergency.
Minimize the need to tap credit lines
Many investment advisors are telling people to be “fully invested”. The rationale is that since returns on stocks are so much higher than fixed-income investments, keeping money in savings is a guaranteed money loser.
From a purely financial standpoint, that advice is spot on. However, many people in that situation rely on credit lines to act as an emergency fund. The problem with that strategy is that it simply pushes the need for cash into the future. Sure, your immediate need for cash will be satisfied by the credit lines. But you’ll need to pay them back later on.
In that way, using credit lines instead of an emergency fund simply transfers the cash needed from the present into the future. You’ll either need to repay the money in one or two large lump sums, or you’ll be adding a new and semi-permanent monthly payment to your budget.
Covering sudden expense related emergencies
Throughout this article, we emphasize an emergency fund amount based on covering a certain number of months of basic living expenses. That implies the primary purpose of an emergency fund is to cover the loss of your income. But while that may be the single most important purpose of an emergency fund, it’s hardly the only one.
Other emergency situations requiring tapping your emergency fund could include:
- A large, unexpected and uncovered medical expense.
- A major car repair, such as the one that runs into several thousand dollars.
- Helping a friend or family member in an emergency.
- Facing an unexpected legal entanglement that will require paying an attorney upfront.
- A sudden and unexpected need to travel, perhaps to take care of an ailing family member.
- A major home repair, not covered by homeowner’s insurance, or where the insurance reimbursement is seriously delayed.
- An identity theft situation that causes you to lose access to your credit lines.
- You receive a notice from the IRS informing you that you owe several thousand dollars in back taxes.
These are just some of the situations that could arise, forcing you to need extra cash in a hurry. If you spend a little bit of time thinking about it, you’ll realize there are many more. A well-funded emergency fund will keep you insulated from each of these situations.
What is the emergency fund calculator?
The Emergency Fund Calculator is practically unique to Money Under 30. There are all kinds of calculators available on the web, helping you do everything from paying off debt to saving for retirement. But there aren’t many available to help you determine how much you should have in your emergency fund. That’s the whole reason we’re offering this calculator.
Determining your target emergency fund amount is basically a math equation. It starts by knowing approximately how much money you need to cover your basic living expenses in a typical month. From there, you can determine the number of months you’ll need to have in your account.
But that’s where the calculation gets tricky, and that’s what the Emergency Fund Calculator is designed to help you navigate.
Often, when currently employed, it’s difficult to estimate how long you might be unemployed after a job loss. What makes this calculator unique is that it gives you options to estimate how long you might be unemployed.
The answer to that will be different for everyone and is naturally highly subjective. After all, it’s not possible to predict the future. But in my opinion, it’s definitely something you should try to do.
How does the emergency fund calculator work?
The purpose of the Emergency Fund Calculator is to help you determine the emergency fund amount you need to have put aside.
It asks you the following:
- Your average monthly expenses – this is how much you would need to cover your basic living expenses in a typical month.
- Existing liquid savings – which is how much you have available already to meet your basic monthly living expenses if you lose your job. It excludes retirement savings since there are tax consequences for liquidating those.
- Your estimate of the degree of difficulty you would have to replace your current income.
The third and final question is of course highly subjective. But even if you think you can replace your income quickly, it might be best to give a more conservative estimate.
It tells you how many months’ expenses to save for
Your answer to the third question will also provide an estimate of the number of months savings you’ll need in your emergency fund. The breakdown is as follows:
- Easy: Three months
- Average: Six months
- Difficult: Nine months
- Very Difficult: 12 months
Ironically, if you fall into either the Difficult or Very Difficult categories, it may be because your industry or field is either stagnant or in decline. If your pay reflects those conditions, it may be difficult to save the amount of money you’ll need to have to cover an income disruption.
Unfortunately, those most likely to face prolonged unemployment require the most generously funded emergency accounts.
Top savings accounts for an emergency fund
Perhaps the best account to hold your emergency fund is a high-yield savings account. The account will not only provide the highest interest possible on your savings, but it will also offer the type of liquidity needed with an emergency fund.
For this purpose, we recommend the following for bank savings accounts: