Some investors start the new year with resolutions to improve their financial situation, and many include an emergency — or rainy day — fund for unexpected expenses such as medical bills or household repairs.
In fact, a recent survey found nearly half of adults (49%) cited building an emergency fund as their top financial goal for 2018, up from 37% in 2013.
A basic plan
Setting aside a pool of money for emergencies can be a practical step to enhance well-being. The ability to tap this reserve can help savers avoid using credit cards or taking out loans to cover unexpected expenses. Savers should consider the bills that may need to be covered when faced with unforeseen medical expenses, a layoff, or separation.
Investors may want to consider using a Roth IRA since contributions can be taken out free of taxes and penalties if the withdrawal is for the exact amount of the contribution. Interest earned on the principal involves separate rules. For an account owner at age 59½, earned interest may be withdrawn without penalty if the account has been open for five years. For those under the age of 59½, withdrawing earned interest results in a 10% early withdrawal penalty.
To make sure contributions are consistent with the Roth, consider setting up automatic deductions from other accounts on a periodic basis. Additionally, income from bonuses or tax refunds could be directed into the emergency account. As the emergency account accumulates assets, it is important to invest the funds so that they remain liquid.
Build savings based on current expenses
Savers can start by calculating basic monthly household expenses, including mortgage, utilities, and food. Recommendations may vary among financial advisors, but the fund should hold enough to cover a minimum of three months’ worth of expenses and possibly as much as two years.
An emergency fund can be helpful to investors in a range of life situations. Some savers may be starting a family and trying to balance new expenses such as childcare. Others may be settling into their retirement budget and find they need extra funds for an unexpected household repair.
After an emergency account is set up and funded, it may be difficult to decide when to make withdrawals. Savers may want to consider a few questions:
- Is it an urgent expense, or is there time to set the money aside in the regular household budget?
- Is it truly an emergency, or is it an issue that can be resolved over time?
- Does the benefit of using the money outweigh the cost? For example, if the cost means depleting the emergency fund entirely, investors may want to consider spending only a portion of the fund and spreading the cost over time.
As investors allocate assets for the year ahead, putting together an emergency fund can be an important part of an overall financial plan. While many surveys found that investors are aware of the importance of an emergency fund and believe it is a priority, they may need guidance to make the commitment and stay on track. The Federal Reserve recently reported that 44% of Americans do not have $400 in savings to cover an emergency expense, and would have to pay for it by either selling an item or borrowing money.
For 2018, savers may want to include another resolution for the new year — meeting with a financial advisor to create an emergency fund as part of a comprehensive plan for the future.
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