An emergency fund is an essential component of a sound financial plan. Having three to six months worth of living expenses in a high yield savings account is recommended by many personal finance experts.

Before deciding how much money you need designated as an emergency fund, there are two big questions you must answer: How many months of expenses should I set aside and which expenses do I need to include?

Although an emergency fund can be used for any necessary, unexpected mishap, it’s traditionally based on how much cash you’ll need if the most expected unexpected event occurs: a disruption in your income. Whether you’re an employee or a business owner, it’s reasonably foreseeable your income won’t always be stable.

So, how many months of living expenses do you need? The questions don’t stop here.

• What’s your risk tolerance? Personally, I sleep better on a nice, plump cushion of cash – more support for my neck. But, you may have a hard time stepping away from the ledge even after you’ve gotten your finances in order. It’s possible you can’t bear the risk of missing out on superior stock market returns because you’re cash heavy.
• Are you the sole or primary breadwinner of your household? For me, it’s just me. I only rely on me. Therefore, I lean towards the conservative side of saving. If I had little kids to feed, then I’d probably be even more conservative.
• What’s the level of demand for someone with your skill set in the marketplace? Lower Demand = Fewer Opportunities = Longer Job Hunt. If you’re highly specialized in a certain field, you might have to relocate to secure employment. From time to time, I think it’s worth while to check out job boards just to see how many employers are looking for individuals with a similar level of experience as you. Do this whether or not you’re looking to switch jobs. It’ll help you identify new proficiencies you may need to develop as well as gauge the overall demand for your services.
• What training is necessary to either update your current skills or develop new ones? It’s possible you and your employer have grown complacent with your existing skills. Other employers may not be so understanding. If you despise your current profession, then there’s little point in becoming more adept at it. Your true calling may require an investment in your education.
• How much does this training cost? Okay, now I’m asking for too much. But seriously, you need to know this. Lacking desirable skills for your chosen career path could extend the length of your employment search.

You may be tempted to factor in non-guaranteed income when deciding how many months of expenses to include in your emergency fund. When faced with the staggering amount of money three to six months of living expenses represent, some people become uncharacteristically optimistic about their chances of collecting on old debts.

If your ex-husband consistently stiffs you on alimony, then don’t count on a windfall arriving just as the rain starts pouring. That money you loaned your cousin eight months ago won’t materialize when you need it either. Forget about that back child support your child’s mother owes you. Who knows when she’ll get a job?

As a matter of fact, anything you have not or cannot independently produce should not be considered. Phantom cash won’t pay the bills. You’ll likely qualify for unemployment benefits if you’re laid off, but you never know. Who’s to say your employment will end involuntarily? If you’re unemployed and you qualify for unemployment benefits then, by all means, take them. But, don’t depend on our government to operate effectively when you’re cash strapped.

Now, on to the next big question: Which expenses are included in an emergency fund?

Your monthly budget is a good jumping off point. For example, the quick and dirty way to calculate a six-month emergency fund is to simply multiply your monthly expenses by six. However, if there’s a break in your compensation there are certain expenses that’ll significantly decrease or disappear altogether.

Daycare, charity (tithes), and work related expenses such as parking  and tolls will all but drop off your budget completely. Presumably, you’ll eat more meals at home. If you have a long commute, the amount you spend on gas will be drastically lower while you’re spending the bulk of your day at home.

There is one very large expense that will probably appear on your budget: 100% of health insurance premiums. Don’t even dream of going without health insurance. A recently published study by the American Journal of Medicine suggests medical debt is the primary culprit behind most personal bankruptcies.

According to the National Coalition on Health Care, the average health insurance premium under an employer health plan for a family of four was almost $12,700 per year in 2008. The annual premium for an individual under an employer health plan was over $4,700 the same year. Expect to foot this bill when you’re jobless.

You can shop around for a better deal when it comes to health insurance, but COBRA (Consolidated Omnibus Budget Reconciliation Act), for the most part, gives you the right to continue coverage under your former employer’s health insurance plan. Individual health insurance is usually more expensive and may prove an impossibility if you have a preexisting medical condition.

There’s a natural tendency to think you’ll greatly cut your lifestyle if you temporarily lose your income. You will. When you totally deplete your emergency fund well before you estimated because you didn’t.

Be realistic. If all you have in your refrigerator is a damp box of Arm & Hammer solidified baking soda and a crusty capped bottle of three year old mustard, then please don’t fool yourself into believing you’ll metamorphosis into Susie Homemaker over night. Recall these are “living expenses,” not “surviving like a pauper, eating fried bologna sandwiches expenses.”

Keeping with being honest, are there any perks you’ve grown accustomed to that are currently provided by your employer? A couple days before my last day at my previous employer, I bought a laptop. I obviously had to return the company provided laptop, which also moonlighted as a personal computer, upon my resignation. Under my current arrangement, I’d have to relinquish my precious iPhone if I were to leave my present employer. I’m not going back to the Motorola RAZR. That ain’t happening.

Now is a good time to talk about what’s not an emergency fund:

• Parents – To the extent you’re capable of providing for yourself like a responsible adult, refrain from asking or counting on your aging mother and father to bail you out.
• Credit – Without warning, this source can suddenly dry up. It sure is strange how banks don’t want to loan you money when they’re unsure how you’ll pay them back.
• Government – They’re incompetent and inefficient – double negative.
• Investments in retirement accounts – It’s likely your retirement accounts harbor long-term investments whose values are more volatile than cash. You don’t want to be in a position where you have to liquidate investments at a loss. By the time you’re able to get back in, the market may have rebounded which would force you to lock in those losses.

You might think the emergency fund I’ve concocted is ultra conservative. It is. After all, cash is king. For an opposing view, check out Brian Scheur’s take on the emergency fund at Building Wealth Together.

This post was featured in the Carnival for Pecuniary Delights #18 – Celebrity Birthday Edition at My Life ROI.

Have I missed anything? Have you ever been unemployed and realized you weren’t adequately prepared financially? If you’ve experienced a life event that required a large sum of cash, what’d you do to address the problem?

I was talking to a friend today about the difference between an emergency fund and a sinking fund.  She heard the term “sinking fund” on The Dave Ramsey Show so she called me up to ask if I’ve ever heard of one.  Well, I listen to The Dave Ramsey Show too, and if I remember correctly, Ramsey describes a sinking fund as cash reserved for necessary, expected, but nonetheless, potentially burdensome expenses.

Investopedia disagrees with Ramsey’s definition.  Actually, a sinking fund is a pool of money set aside by a company to help repay a bond issue. It does seem as if Investopedia and Ramsey agree on the spirit of a sinking fund, so let’s go with Ramsey’s definition since it’s sexier.

An emergency fund is for – well – an emergency: a sudden, urgent, unexpected event that requires immediate action.  As far as I can tell, an emergency fund and a sinking fund serve the same purpose except one is built in anticipation of the unexpected knocking you off your feet while the other is not.

Here’s a list of some of my personal emergencies:

• I locked my keys in a gym locker. Since I used an ultra hardened lock, I had to hire a locksmith to saw it off the locker. That cost about $90.
• A family member passed away, and I had to fly home for the funeral. The last minute flight set me back roughly $400.
• My car failed it’s safety inspection due to worn brake pads.  The replacements were $180.

I didn’t think any of these things would happen when they did.  If the cash in my checking account was insufficient, then theses expenses could’ve been paid with money from my emergency fund.

Contrast the events listed above with the following:

• Your 25 year old roof begins to leak. That’ll be $14,ooo.
• Betsy, your 1995 Geo Prizm who can’t pass a safety inspection to save your life, has to be put down.  A realiable set of wheels is running around $8,000.
• The refrigerator you happened upon while dumpster diving and have been using for the last five years dies.  You don’t want to push your luck so you pick up an imperfect substitute for $500 at the Sears scratch and dent warehouse.

Use your sinking fund to pay for these.  You know roofs don’t last forever and neither do cars and neither do refrigerators.  You get my point.

You’re probably saying to yourself, “what difference does it make as long as I have the money to pay for this stuff when I need to?”

So what happens if the cost of the roof wipes out your emergency fund, then you need to pay for expensive dental surgery? Dental insurance stinks.

Don’t let something you could’ve planned for leave you financially vulnerable to circumstances you have no way of predicting. I know it’s a lot of cash to have on hand, but that cushion will help you sleep better at night if either the expected or the unexpected come calling for your immediate attention.