Today’s hard financial reality can change your life in the blink of an eye. Financial crisis can hit on your door in all shapes and sizes taking the form of a job loss, home or car repair, or huge medical bills. Some people choose to liquidate their 401k plan or to borrow from their credit card.
However, there is a more effective way to save for the rainy days: setting money aside in an emergency fund.
Why is an emergency fund important?
Most Americans borrow from their IRA accounts or withdraw money from their 401k funds to handle their financial emergencies. Although the 401k is a retirement plan and not a savings account, the government allows you to borrow from your 401k plan. However, by liquidating your 401k, you are automatically subject to higher taxes and penalties.
If you liquidate your 401k before the age of 59 ½, the retirement funds will be taxed, and you will face a 10% early withdrawal penalty.
Furthermore, you may think that borrowing money from your credit card is not that bad. Well, in fact, it is very bad because once you start charging your credit card, you will enter a never-ending spiral of charges, which will lead to high-interest rates and a huge credit card debt. Therefore, sooner or later, you will be required to take care of your credit card debt as well on the top of the existing for which you used the credit card.
On the other hand, if you set up an emergency fund, you will have money aside to borrow if you face an unforeseen financial situation, thus avoiding overcharging your credit card or liquidating your 401k plan.
How much money should you set aside in an emergency fund?
Most financial experts suggest that keeping three to six months’ worth of your living expenses in an emergency fund is enough to anticipate a financial emergency. For instance, three to six months of saved money will cover up for a loss of job until you find new employment.
Of course, it also depends on your marital status, how many people are there in your family, how much debt you carry and so on. In any case, you can start saving today.
Where will your emergency fund be safe?
Since an emergency fund is a fund you keep for emergency situations, you should make sure to keep it safe. This automatically eliminates placing your money – even a small part of it – to a stock market portfolio.
No matter how well-diversified your portfolio is, the volatility of the stock market may lead to huge losses. Instead, you can place your emergency fund to a money market account (MMA) that allows you to withdraw your money up to six times per month with no penalty fees. Furthermore, with an MMA you will have a higher interest on your deposit.
Alternatively, you can place your emergency fund to a regular interest-paying checking account or a certificate of deposit (CD). Although a checking account allows for frequent withdrawals and limitless deposits, it does not offer a high-interest-rate. With a CD, you will be charged a penalty fee for early withdrawal.
Another option is a money market mutual fund that allows you to hold a portfolio of diversified, low-risk, short-term securities with an average maturity of 90 days. The only consideration is that a with a money market mutual fund is not insured by the Federal Deposit Insurance Corporation (FDIC), and therefore, it incurs a slightly higher risk.
Once you set up your emergency fund, put your savings on auto-pilot to know how much money you save each month. Cover your household expenses and save an extra amount of money as a cushion to your monthly budget. Decide on a percentage of your monthly income that you want to set aside and transfer it automatically to your emergency fund.