In Case of Emergency...
In fair weather prepare for foul.
-Thomas Fuller
I heard a story once about a farmer that needed to hire a worker to live and work on his farm. Finding someone proved extraordinarily difficult, and the interview with the only person he could find was strange. The farmer asked the gentleman if he could do the work, and his only words were: “I can sleep when the wind blows”. The farmer didn’t know what to think but needed help so desperately that he hired the gentleman anyway. It soon became clear that the gentleman was a good worker, and the farmer was pleased. However, one evening a massive storm threatened the farm. The farmer rushed to wake the gentleman to get his help to prevent catastrophic damage, but he couldn’t wake him. Desperately the farmer ran to secure the harvest and tie down the equipment, but to his incredible and delighted surprise he found that his worker had already secured everything. It was then the farmer understood the words: “I can sleep when the wind blows”.
As a Certified Financial Planner™, financially speaking I know that few things can provide the peace and security that an emergency fund can provide. It allows you to “sleep when the wind blows”.
What Exactly is an Emergency Fund?
An emergency fund is when you have cash in a savings account for unexpected (i.e. emergency) expenses. Examples of such expenses include auto repairs, medical expenses, or home repairs. I recommend three months’ worth of expenses in savings if both partners work. For example, if your monthly expenses (mortgage/rent, food, utilities, etc.) was $2500, then you should have $7500 in emergency savings. You will need between four and six months’ worth of expenses if you are single or just one partner works, as you only have one income to rely on. Sadly, far too many Americans don’t have an emergency savings as 58% could not come up with $1000 in the event of an emergency (1).
This data was from before the pandemic. Since COVID-19, things have only gotten worse. Pew Research recently conducted the following survey that revealed the impact on various socioeconomic classes. In addition to lower income adults being among the hardest hit by the economic fallout from COVID-19, they are less prepared to withstand a financial shock than those with higher incomes. Only about one-in-four (23%) say they have rainy day funds set aside that would cover their expenses for three months in case of an emergency such as job loss, sickness, or an economic downturn, compared with 48% of middle-income and 75% of upper-income adults. And while 53% of lower-income adults say they will have trouble paying some of their bills this month, about a quarter of middle-income adults, and 11% of those in the upper income tier, say the same (2).
Types of Emergency Funds
While the concept of an emergency fund is relatively simple and straight forward, there are some conventional and non-conventional emergency fund options to consider. However, it is recommended that in most cases you stick with the conventional type of emergency fund (i.e. money in the bank).
Conventional Emergency Funds
This type of emergency fund is simply money in the bank. Pretty boring stuff. Unfortunately saving account interest yields are incredibly low at present, between 0.01-0.05%. Put another way, for every $10,000 you have in savings the bank pays you between $1.00-$5.00 per year. That’s not a typo; it’s just that bad right now. I recommend clients look to online savings accounts as they can provide much more yield. Examples include allybank.com, marcus.com, capitalone.com etc. Yields on these accounts are between 0.50% - 0.60%, or $50-$60 per year for every $10,000 invested. Not great either but better than what you would receive in a brick and mortar bank account.
If you don’t have enough saved in your emergency fund the most effective way to build it is first to budget your money and put any extra money into a savings account until you are where you need to be. See my blog on budgets - https://www.betterplanningbetterlife.com/blog/the-b-word
Unconventional Emergency Fund Sources
What if at present you don’t have an emergency fund? Rest somewhat assured that there are some unconventional sources that could provide funds in a time of need. However, it should be noted that some of these may take more than a few days to access. Typically, emergency money is what you can access immediately, but these unconventional emergency fund options can help in a pinch.
401k loan
Many 401k plans have a loan provision that allows participants to take out 50% of their account balance or $50,000 - whichever is less. You will need to pay back the loan over time with interest, and if you leave your employer before you pay the loan back you will need to pay the remainder immediately. If you are unable to do so, it will be considered a distribution that may include an additional 10% tax penalty.
CARES ACT — It should be noted that during the recent pandemic, Congress passed the CARES Act that permitted people to take out $100,000 from a retirement plan or IRA. You will still need to pay taxes on the distribution, but those distributions can be spread over 3 years. Additionally, the 10% penalty is waived for those that qualify. Qualifications include you, your spouse, or your dependent(s) being diagnosed with COVID-19, or you are experiencing adverse financial consequences as a result of being quarantined, furloughed, laid off, having work hours reduced, or being unable to work due to lack of child care.
IRA - Indirect Rollover 60-day rule
Most rollovers happen as direct transfers that go from one retirement account directly to the other. For example, you rollover your IRA at Morgan Stanley to your IRA here at Capital Investment Advisers/LPL Financial. In other words, Morgan Stanley and LPL transfer the funds between your IRA accounts on your behalf. However, there are also indirect transfers where the individual owner of the retirement account takes the money out of an IRA that they can personally reinvest into another IRA, or they can reinvest back into the same IRA without any taxes or penalties if done within 60 days. However, this can only be done once every 365 days, and the 60-day clock starts upon the first withdrawal. If you don’t return the funds within 60 calendar days, you will be taxed on the distribution and incur a 10% penalty if you are under age 59.5.
Roth 401k/IRA Contributions
A Roth is a retirement account to which you contribute after-tax funds. What many people don’t realize is that because you have already paid taxes on these contributions, the IRS allows you to withdraw the contributed sums (not the gains) at any time without taxes or penalties. Consequently, a Roth IRA can double as an emergency savings account. However, building wealth is about leaving these funds to compound over time.
Like the indirect rollover rule, you can redeposit any withdrawals within 60 days.
Roth Contribution example: Let’s say you contribute $5000 to a Roth IRA in 2015 and it grows to $10,000 in 2020. You can take the $5000 contribution out with no taxable consequences. However, the disadvantage is that less of your money will be compounding.
Other Sources
A few other sources would include a non-retirement annuity or Cash Value Life Insurance if you have either of these. Due to the high commissions and expenses associated with these products, an annuity and especially cash value life insurance, would not be considered a way to start an emergency fund. Cash value life insurance only makes sense for High Net Worth individuals (>$10 million), and even then, it’s debatable.
Corporate America has a Solution
Finally, corporate America has recognized how important it is to have an emergency fund for their employees. Recently United Parcel Service Inc. (UPS) was expected to announce a plan to offer nearly 100,000 of its workers a way to save for emergencies within its 401(k) plan becoming one of the largest U.S. employers to join a trend that reflects concern over the impact of workers’ financial problems on their ability to retire.
The program gives UPS employees the option to divert a portion of their paychecks into rainy-day funds within their 401(k) plans (3).
Final Word
Emergency funds are a lot like seatbelts or insurance - they aren’t very exciting but are sure helpful in a time of need! These funds can help make a bad situation better, and without them, it can make a bad situation worse. So, the next time the economic storms are bearing down, be sure to have an emergency fund in place so you can “sleep when the wind blows”.
Thank you for reading, and if you have any questions feel free to reach out.
https://www.cnbc.com/2019/01/23/most-americans-dont-have-the-savings-to-cover-a-1000-emergency.html
https://www.wsj.com/articles/ups-to-offer-employees-a-way-to-save-for-emergencies-11603360801
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The hypothetical examples listed above are not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing. Investing involves risk including loss of principal. No strategy assures success or protects against loss. The economic forecasts set forth in this material may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
