Emergency funds get a lot of attention. For good reason. It’s important for your financial health to be prepared if a sudden financial need arises. If there is no room in your budget for those ‘life-happens’ moments, then you are going to find yourself in more debt. Worse yet, you may no longer have any extra room on your credit cards or other places to borrow from in a financial emergency. Then what?
Obviously, we think that preparing for life’s surprises is achievable through planning and saving. Saving is one of our primary focuses, afterall. We often hear that everyone needs 3, 6 or even 12 months of living expenses saved up, just in case. But, is that always true?
What is an Emergency Fund For?
If you are like us, you’ve been saving for your retirement for a while and you are careful planners – chances are that most of life’s curve balls can not only be anticipated, but planned for and met with good saving habits.
Let’s think about what possible emergencies you may face and how to avoid drowning when they hit you.
Now that we covered the doom-and-gloom. Let’s talk for a minute about what some people consider ‘emergencies’. Your emergency fund is not a pool to dip from to source vacations for example, or to pay for a new wardrobe or a new car simply because you feel ‘you deserve new stuff’. These things are not emergencies! You certainly can go on vacation and buy yourself new clothes or replace your car from time-to-time, but these are expenses that you can predict, plan for, and save up. If you want to be successful in reaching your financial goals, you have to be disciplined not to drain your accounts for non-emergencies.
How Your View on Emergency Funds May Change
If you are like us, on a long journey to Financial Independence and planning to Retire Early, your needs will likely change over time as you flex and develop your financial prowess.
Let’s examine the different phases you may go through on your journey.
Phase 1: The Kiddie Pool
In the Kidde Pool phase, you probably have never heard of the term ‘FIRE.’ You probably consider yourself ‘living paycheck to paycheck’ and may have significant debt that you are struggling with. You need to take drastic measures to change your fate. You definitely need to be in sight of the lifeguard at all times in case you start to drown.
Don’t dispair. It’s never too late to pull yourself together. Be honest. If you could not pay for a modest car repair, of say $800 – you are pretty desperate. You need to establish and grow an emergency fund and cut as much spending as possible. Prioritizing a small emergency fund would be a prudent move to avoid sinking further into debt until your situation improves. At this phase, you probably could only afford to set aside a couple or few thousand dollars and then target your high interest consumer debt before beefing up your EF further. The important part is that you set a reasonable goal and keep working at it until you have a little set aside to ride out the storms.
Phase 2: Doggie Paddle
Okay, so maybe you learned a few swimming tricks and you can tread water for a while if need be. You may have some room on your credit cards if needed in a pinch and you may have started to save for various purposes. You are working hard to eliminate your debt and you are practicing basic budgeting and savings skills.
In this phase, you could handle a small sudden expense. However, anything major such as replacing your HVAC system or a hospital stay for emergency gall bladder surgery, would seriously throw you into the deep end. If you are in this phase, you probably still need to grow your emergency cushion to keep you afloat. Continue to pad your EF until it’s at level you are comfortable with based on your personal circumstances. Are you a one income or dual income family, for example? How much non-mortgage debt do you still have? Here is where serious reflection will help you decide if 3 months is enough for you or if you need 6, 9, or even 12 months set aside.
Phase 3: Proficient Swimmer
By this phase, you are competent at all the common strokes. You can do the back stroke, the breast stroke and freestyle without getting water up your nose (butterfly is definitely more challenging!). You have a solid financial plan and stick to a regular budget or spending plan. You rarely, if ever, have any surprise expenses that you couldn’t find the funds for in a few days or weeks.
In this phase, you may consider whether having 6 months or more in an emergency fund is overkill? The longer you are in this phase, perhaps you can scale it back some. Maybe you cut your EF in half and invest the difference to help you achieve your other financial goals faster?
Phase 4: Olympic Swimmer
In this phase, your inner Phelps or Ledecky is shinning bright. (Hey, remember we are from Maryland afterall). There is no wave large enough to pull you under!
Obviously, there are serious unforeseen events that could happen to any of us, but you have a contingency plan for just about everything. Health care expenses? No problem – I have a sizeable HSA for those. Car replacement? No problem – I’ve been saving up for this since I bought the last one. At this point, you probably have significant credit available to you on your credit cards (which you pay off every month) or maybe you have a taken out a HELOC if you own a home. Point is, that you probably have borrowing capacity to float you for a while. And you have investments which could be sold if need be as well.
Do Retirees Need an Emergency Fund?
Maybe, you are already retired. Do you need an Emergency Fund then? Well maybe, but maybe not. If you are good about anticipating all possibilities, perhaps you need a very small EF or no EF at all. If you are retired by choice, we assume you have sizeable assets available to you and either a steady stream of passive income or you have a safe withdrawal strategy that you can tweak according to current conditions and needs. You can be flexible if your situation changes, right?
Maybe a key part of your retirement strategy is to have a certain number of months of living expenses set aside in cash from which to draw to control when you sell certain investments. That is fine too, but then is this really still an Emergency Fund? Isn’t it your living expense fund for those months or years? In other words, it’s no longer an “Emergency.” These are the funds you plan to live off of, right?
Who Absolutely Needs an Emergency Fund?
If your pay is highly variable and lumpy, then you need a larger cushion to ride out the ebb and flow of your income. Whether or not you call it an emergency fund or not, you have to make those funds stretch between your paydays.
Growing up, my dad was a real-estate agent. Those commissions are some of the lumpiest out there. In a down-market, he could go months, even up to a whole year with little to no income. It wasn’t hard to tell when dad was doing well with strong sales and when he was carefully scrimping until the next commission check was earned. Those thin earning times were stressful on him. He did a pretty good job of holding on to his money to make it last, but it didn’t always.
What We Are Doing
The Need2Save family is solidly in Phase 3 but we feel like Phase 4 isn’t too far away. We are blessed that we haven’t had an emergency that required us to deplete our EF. But it’s probably bigger than it needs to be right now. We are unlikely to need 6 months of living expenses between now and when we retire. One of the reasons for this is that we have other savings to tap in to if we needed to. We have our Health Savings Account (HSA) balances to tap in the case of medical expenses (over $30,000 between the two of our accounts). We have a savings fund for car maintenace and replacement needs should one of our cars need attention. We have savings for house maintenance should the water heater die. Our jobs are very steady and there is no threat of losing our full-time jobs for the foreseeable future. Once we pay off our mortgage, I think we will be ready for the Olympic team.
But wait Mrs. Need2Save! What about the opportunity costs? Look how much money you are losing by just sitting on iddle cash! I don’t mind sitting on a certain amount of cash just-in-case we need it and because it is a small portion of our overall retirement savings, the ‘opportunity cost’ doesn’t bother me much. In fact, if we keep around $15,000 – $20,000 in our emergency fund, it’s less than 2% of our overall assets. We have plenty of other assets working hard for us in the market. That said, we no longer contribute to our EF and invest a significant portion of our discretionary income.
Further, as we think ahead for cash flow during our ‘gap years’ (between when we stop working our full-time jobs and when we plan to start drawing on our pre-tax investments), we are counting whatever balance is left in our EF upon reaching our early retirement goals as part of our pre-60 spending plan. So really, our EF will eventually morph into the baseline for our gap year spending plans. Learn more about Our Early Retirement Goals.
It’s perfectly normal to move through different phases in your life. Your needs will evolve over time the closer you get to your retirement goals. Ours certainly have and we have adjusted accordingly. Like many areas in ‘personal’ finance it’s all about where you are in your financial journey. If you are just starting to get your financial life in order, then you are probably in Phase 1 and need that life ring to keep you from drowning. But, if you’ve been killing it for years and are close to your financial goals, you are probably closer to or even in Phase 4 where having a significant Emergency Fund may be overkill.
Tell us about your view on emergency funds? Are you still in the Kiddie Pool or a nearing Olympic Swimmer status? How much in reserves are you comfortable with for ‘just in case’ emergencies?