Five myths about emergency funds
Being prepared for emergencies is an essential part of sound financial planning.
I typically advise my clients to keep three to six months of basic living expenses 鈥� such as their rent or mortgage payments, groceries and child care costs 鈥� set aside in their checking or savings accounts. This helps them avoid resorting to credit cards to cover unexpected bills.
But I find my clients聽still have questions about how to manage emergency funds and balance them with investments. Here are five聽聽myths I鈥檇 like to debunk.
Myth No. 1: If I want to grow my emergency fund, I should put it in聽.
Truth: Your emergency fund and your investments are different accounts with different goals.
Your emergency fund should be cash you can access easily, whereas your聽investments should be growing for the long term. Tapping them early can聽lead to problems. For example, you鈥檒l lose out if you have to withdraw money during a downturn, while long-term investors can gain their money back and then some when markets recover. And no matter when you withdraw, you鈥檒l lose the money鈥檚 potential for long-term growth. You might also pay penalties if your early withdrawal is from a qualified retirement account, such as a 401(k).
You can easily see the risk of using your investment accounts as an emergency fund if you look at聽recent history. Just think if you鈥檇 lost your job in 2008, as the stock market was crashing 鈥� causing your emergency fund to lose 30% or 40%.
Retirees who live on their investments are the one exception to this. But they still聽need a well-thought-out strategy to ensure that their distributions and cash flow are sustainable.
Myth No. 2: I should save as much as I possibly can in my emergency fund.
Truth: Maximizing your emergency fund can be聽a missed opportunity to grow your net worth.
Right now, interest on savings accounts is close to zero. The national average APR for a normal savings account is 0.5%, and high-yield savings accounts and money markets yield between聽0.75% and 1%.
Let鈥檚 say you started with $10,000. After 10 years, you鈥檇 have $16,665 if you put that money in a normal savings account, $17,368 if you put it in a high-yield savings account, or $28,272 if you put it in an investment account and earned about 7% each year 鈥� that鈥檚 more than double the original investment.
Keeping too much cash is counterproductive聽in聽our聽low-rate environment. Be efficient and keep the right amount of cash in the right types of accounts.
Myth No. 3: I need to save three to six months of my current level of spending.
Truth: Save three to six months of basic expenses to avoid having an聽unnecessarily high level of reserves.
To determine how much you should have in your emergency fund, identify your 鈥渃ore expenses,鈥� which represent the amount you absolutely need聽to live on without going into additional debt. You don鈥檛 need to include discretionary spending 鈥� such as cash for hobbies, spa treatments or vacations 鈥斅爄n this figure.
Myth No. 4: I don鈥檛 need an emergency fund once I reach age 59陆聽because I can take money out of my retirement account without penalty.
Truth: The tax 鈥減enalty鈥� never really goes away.
After age 59陆, the 10% penalty for withdrawing from a pretax account, like a workplace retirement plan, goes away. So if you鈥檙e older than that,聽but still working, you might wonder, 鈥淲hy not tap my 401(k) for emergency needs?鈥�
The reason is that when you聽, it鈥檚 treated as income for tax purposes. That means you not only have to pay income taxes on it, but it might put you in a higher tax bracket.
For example, a client of ours broke a hip and now needs rehab care for 20 days at a cost of $11,520. If he聽took that from a pretax investment account, he鈥檇 need to withdraw about $16,000 to cover taxes. That鈥檚 almost a $5,000 鈥減enalty鈥� before considering the consequences for his tax bracket.
The burn rate on money is greater when it鈥檚 pulled from tax-deferred accounts. Liquidity is very important for a retiree, so if you don鈥檛 already have after-tax money, now is the time to start saving.
Myth No. 5: I should never touch my emergency fund if I can possibly avoid it.
Truth: Don鈥檛 use your emergency fund to pay for shopping sprees, but remember that not all emergencies are life or death.
If your choice is to withdraw聽funds from an emergency account or to take on credit card debt, you should use the emergency funds in most scenarios.
At the end of each quarter, evaluate when you had to pull from the emergency account. Were they costs you聽could have anticipated? Were you just overspending?
Consider setting aside some money each year, on top of the three to six months of core expenses, for household and automotive maintenance and repairs. You might not know exactly what will break, but you can be fairly certain that wear and tear is going to happen.
It can give you聽peace of mind to know that you鈥檙e prepared no matter what 鈥� and if you end up not using all of those funds in a year, you can add the surplus to other financial goals.
Proper cash flow management takes discipline, but it鈥檚 something you can learn and improve on over time. The payoff of lowered stress is well worth it.
聽is the president and founder of聽, an independent fee-only wealth management firm with offices in Rockville, Maryland, and Ashburn, Virginia. This article first appeared at .听Learn more about Ted on NerdWallet鈥檚聽.
