Have you given some thought to setting aside money for a financial emergency? Whether it's in case you lose your job, need to replace the furnace or have an unexpected car repair, your goal is to make sure you're covered.
Tradition says it's prudent to have six months of living expenses set aside in a savings account or a money market account. While it’s important to be prepared, it’s also important to give some thought to whether you need that much emergency money. Yes, if your job is tenuous and you are the family's sole breadwinner, keeping the full six months or more may make sense. However, if both you and your partner or significant other work, you may need less, because you could cut back spending and live on a single paycheck if one of you loses your job.
A caveat: The smaller emergency fund may not be sensible if there's a risk you could both be unemployed at the same time because, say, you work for the same company or in the same industry.
If you've managed to save a moderate amount of money, keeping a separate emergency reserve may not be necessary. In addition to tapping taxable accounts for a source of funds in the event of an emergency, other options that you may wish to consider after reviewing the risks, with your tax advisor and others include:
- What happens if you borrow against a life insurance policy's cash value? Advantages to borrowing against a life insurance policy can be easy qualification and quick access to funds. As long as your policy’s cash value is above the minimum amount required by your insurer, you can have access to funds in just a few days. It is also important to be aware that if you don't repay the loan—plus the interest charged—your policy's cash value and its death benefit may decrease, or even lapse if you leave your policy underfunded. If the total amount withdrawn exceeds the premiums paid for the policy, the excess may be considered taxable income.
- What happens if you borrow from your 401(k) plan? When borrowing from a 401(k) plan, the application process is usually fairly simple. This option can help you receive potentially lower interest rates compared to traditional loans and as long as you follow the strict payment schedule, you won’t face any penalties or taxes. While there can be benefits, this option may involve some ﬁnancial risk. If you can't repay your 401(k) loan, it may be considered a distribution, possibly triggering income taxes and probably an additional 10% percent tax penalty. Many employer 401ks have ﬁnancial hardship provisions that permit withdrawals/loans.
- What about Funding a Roth IRA? You can save for retirement on an after-tax basis, grow the account on a tax-deferred basis, and potentially also build up an emergency reserve at the same time. If you get hit with a financial emergency that your other savings do not cover, you could pull the funds you initially contributed at any time without taxes and penalties (but not necessarily the earnings on those contributions).
Prepping your finances
As you ponder how you might cope with a financial emergency, don't just consider where you'll turn for cash. Also look to keep your cost of living under control, including:
- Aim to keep your core living expenses at 50 percent of your pretax income or less. These core living expenses consist of things like mortgage or rent, consumer-debt payments, utilities and food. That means the other 50 percent would be going to items such as income taxes, monthly savings, vacations, eating out and entertainment. Presumably, if you lost your job, these other expenses would largely or entirely disappear—and you could get by on half of your old salary.
- Raising the deductibles on your homeowner's and auto insurance and extending the waiting periods on your disability and long–term care policies. Thanks to your emergency fund, you would now have some money set aside to help pay for financial mishaps, so it's likely you wouldn't need quite so much insurance coverage. If you were to decide to keep the same insurance coverage amounts while you are unemployed or had only one income provider, you might consider discussing with your P&C insurance provider the advantages and disadvantages of temporarily increasing your deductibles to lower your premiums. Indeed, with any luck, the savings on your insurance premiums would compensate for lower returns you'd be earning on your emergency money. But be warned: If you have an insurance claim, your out–of–pocket cost will likely be greater.