Emergency Fund

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 without going overboard.

Conventional wisdom says it's prudent to have six months of living expenses set aside in a savings account or a money–market. 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 may make sense. However, if both you and your spouse 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 prudent if there's a risk you could both lose your job 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 in your accounts, 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, including the risk of loss of compounding, with your tax advisor and others include:

1. What happens if you borrow against a life insurance policy's cash value? Be aware that if you don't repay the loan—plus the interest charged—your policy's cash value and its death benefit will decline. In addition, if you don't repay the loan plus interest, your policy could lapse. If the total amount withdrawn exceeds the premiums paid for the policy, the excess would be taxable.
2. What happens if you borrow from your 401(k) plan? 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 a 10 percent tax penalty. If your employer offers a 401(k) matching contribution, you may still come out ahead funding the plan and getting the match, even if you later have to cash out the account and pay income taxes and tax penalties.
3. What about Funding a Roth IRA? You can save for retirement on an after-tax basis, grow the account on a tax-free 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.

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.

1. Aiming 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.
2. 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 now have the money to pay for financial mishaps, so presumably you don't need quite so much insurance coverage. The higher deductibles and longer waiting periods should lower your premiums. Indeed, with any luck, the savings on your insurance premiums will compensate for the low return you're earning on your emergency money. But be warned: If you have an insurance claim, your out–of–pocket cost will likely be greater.

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.