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  • Katherine Fonville

Emergency Fund: What it is, Why it Matters, and How to Build One

Emergency Fund: What it is, why it matters, and how to build one

Has the global COVID-19 pandemic prompted you to rethink your money moves?

Bravo if you put establishing an emergency fund at the top of your list. An emergency fund is one of your most powerful tools to weather life’s crises.

But what is it and how can it impact you? Let’s take a closer look.

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What’s an emergency fund?

Simply put, an emergency fund is your personal financial safety net. It’s highly liquid, such as a cash or money market account kept separately from your regular checking and savings account, and set up to cover large, unexpected expenses.

What kind of expenses? You may be thinking “gas line repair,” “new roof” and “unforeseen medical expenses.” Six months ago, these may have been at the top of the list.

But the ongoing pandemic has shifted our thinking. Now many people want to earmark that emergency fund as their primary source of support for themselves and their families in case of unemployment. Since March, more than 40 million Americans of all income brackets and occupations have lost their jobs because of COVID-19 and the subsequent economic fallout. Although some hiring has resumed, uncertainty prevails.

You want to be prepared.

Depending on your family situation (single, married, a working spouse, minor dependents), aim for emergency savings to cover up to nine months of expenses you may have to pay due to unemployment.

That buffer will allow you to continue paying your monthly rent or mortgage, food and medications, private school tuition, utilities, car loan, insurance, plus property, and real estate taxes.

For example, Susan and David have expenses totaling $9,000 per month. They both work full-time, but if Dave were to lose his job, then Susan's salary would only cover $3,000 of their monthly expenses. This leaves $6,000 per month in expenses that they won't be able to cover. Susan and David should target $42,000 to $63,000 for their emergency fund. This equates to six to nine months of expenses.

Emergency funds aren’t just for working families, even retirees still need a healthy emergency fund. We typically encourage our retired clients to have between one to two years of expenses saved up in an emergency fund or as part of their overall retirement portfolio. It’s good to have cash on hand in case of any dips in your nest egg.

Create a separate rainy day fund

In addition to your emergency fund, you want a rainy day fund. This is a smaller savings account, also kept separate from your regular checking account, for life’s less traumatic hiccups: new tires or a malfunctioning water heater. Try to build up $2,500 to $5,000 in this account or the equivalent of one month’s pay.

Why do you need both?

An emergency fund preserves your financial security and boosts your peace of mind. You will withstand life’s major blows much better if your finances are in good shape.

Consider the benefits of an emergency fund:

  • Intact retirement accounts. You won’t have to dip into your IRA, 401(k) or Profit Sharing Plan. Those withdrawals, while permissible under IRS rules for certain expenses, might cost you dearly in terms of lost investment earnings, income taxes and possibly, penalties. That could mean delaying your retirement or jeopardizing your lifestyle in retirement. No need to face those consequences if you have a well-endowed emergency fund.

  • Control over your investments. You want to decide when to sell your securities so you can minimize losses when stocks are down and excessive capital gains taxes when stocks are up. A financial crunch could necessitate unfavorable selling choices, but an emergency fund lets you stay in charge.

  • No new debt. The last thing you need during a major crisis is additional debt from credit card spending or personal bank loans. Credit card debt, in particular, can wreak havoc on your finances, especially if you, like almost half of all Americans using credit cards, carry balances from month to month. Credit card interest rates are among the highest on any consumer debt, exceeding 17% on average, and late fees carry an additional punch. More debt also harms your credit score, making it even more expensive to borrow. It’s a scenario you can avoid if you have money squirreled away in an emergency fund.

  • Maintain personal relationships. You probably know this proverb: “Before borrowing money from a friend, decide which you need more: the friend or the money.” Asking friends or family members for loans typically strains the relationship even if you manage to pay back all that you owe.

  • A good night’s sleep. You’ll sleep better and have an optim