Building an emergency fund is money management 101. You could lose your job, get pregnant unexpectedly or discover your health insurance doesn’t cover a costly medical procedure.
Like the grotesquely, entertaining Spike TV show, 1000 Ways to Die, there are, at least, a 1000 reasons you’d need to get your fingers on a hunk of cash – quick. But mostly, the emergency fund comes to the rescue whenever you suffer a drastic decrease or complete loss of income.
The ideal size of an emergency fund varies among experts. Dave Ramsey says 3 to 6 months’ of living expenses. Suze Orman says you need 8 months’ worth of living expenses while Ric Edelman recommends no less than 12.
Based on this guidance, the formula for calculating the size of your emergency fund is simple. Tally up your monthly expenses. Then, multiply the resulting amount by a minimum of 3 or a maximum of 12. So, in theory, $20K will last 8 months if you have no income, and your monthly living expenses are $2,500. Right?
Let’s count the ways.
1. Not Making Your Emergency Fund Big Enough
You may be tempted to underestimate your monthly variable expenses. Fixed expenses such as rent, insurance and student loan payments are difficult to lie about. Food, entertainment and personal care allow for a bit more magical thinking. The money you need to save shouldn’t be based on a fairy tale in which you forgo tiny luxuries.
Even in the event of a job loss, you won’t suddenly change your spending habits. If you’ve had a standing bi-weekly hair appointment for the last 7 years, include this expense in your calculation.
2. Counting on Your Emergency Fund to Cover Non-Emergency Expenses
As long as I can remember, Christmas has fallen on December 25th of every year. If you’re driving a 15 year old clunker, isn’t it reasonable to assume you’ll need another car soon?
If you can anticipate with almost absolute certainty that an event is likely to occur, it’s not an emergency. Don’t violate the spirit of an emergency fund. Set up another bank account, and save for predictable expenses separately.
3. Forgetting to Factor In Employer Paid Expenses
There’s one expense that’ll wipe out any savings that may occur from a job loss: health insurance. While you’ll likely notice a reduction in transportation costs, you’re gonna be on the hook for 100% of health insurance premiums.
According to the Kaiser Family Foundation, in 2010, average annual health insurance premiums were about $5,000 for an individual and about $14,000 for a family. That’s a lot of money to overlook.
Additionally, if your employer is paying for your gym membership, cell phone bill, and other perks, get ready to pay up for those.
4. Assuming Credit Is a Viable Substitution for An Emergency Fund
By definition, credit is someone else’s money. As a result, access to it can be taken away at any moment. Besides, do you think it’s a good idea to go into debt when you’re faced with a crisis?
5. Looking to Retirement Accounts for an Emergency Bailout
Cash out a traditional 401(k), a traditional IRA, or other tax deferred retirement account before you’re 59 1/2 years old, and you’ll likely get slapped with a 10% early withdrawal penalty in addition to any income taxes you’d owe at any age.
Even borrowing from a 401(k) can be costly. Yes. You repay the 401(k) loan to yourself, with interest. But you’ll pay double the taxes for this privilege. Once when you repay the loan with after-tax money and again when you withdraw the funds in retirement.
Lose your job before paying off the balance of a 401(k) loan and you, most likely, have only 60 days to repay the entire outstanding balance. Fail to do so, and the unpaid balance is considered a withdrawal subject to taxes and penalties.
What other issues have you overlooked when saving for an emergency fund?
This post was mentioned in the Carnival of Personal Finance #320 – Plutus Awards Edition at Canadian Finance Blog.