YOUR PLAN FOR financial emergencies might have four components: a cash reserve, credit lines, a Roth IRA and low fixed living costs.
One rule of thumb says that, as an emergency reserve, you ought to keep six months’ living expenses in conservative investments, such as a savings account or a money-market fund. This can be a heap of dough. For instance, if you make $75,000 a year, you might need to set aside $25,000 to cover your living expenses for half a year. Even if you’re a diligent saver, it would likely take you at least a few years to accumulate that money. And once you have the money, it will probably languish in a savings account or a money-market fund earning precious little interest.
Could you make do with a smaller emergency reserve? You might hold less emergency money if you have easy access to borrowed money. We talk about credit lines and other ways to borrow in the chapter on borrowing.
You might also keep a smaller emergency reserve if you have funded a Roth IRA. You’re allowed to withdraw your regular annual Roth contributions at any time, with no taxes or penalties owed. We discuss that further in the chapter on taxes. The implication: If you make a concerted effort to fund a Roth early in your working career, it could serve double duty, helping to pay for retirement if everything goes well—and bailing you out financially if it doesn’t.
In addition, you might keep a smaller emergency reserve if you focus not on covering your family’s total monthly living expenses, but on putting aside enough to cover just your family’s fixed costs, such as mortgage or rent, car payments, utilities and groceries. The idea: If you lose your job or have some other type of financial emergency, you would slash discretionary spending and instead limit yourself to expenses that are absolutely necessary. The lower these fixed costs are, the less emergency money you would need.
In the end, the size of your emergency fund will likely hinge on one question: How secure is your job?
Next: What Size Cash Cushion?
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