Setting up an emergency fund is one piece of advice that seems to be a consensus among the general personal finance community.
This is something that financial advisors commonly recommend and is usually targeted as one of the first things to prioritize when starting out (usually after paying off high-interest debt).
For those who don’t know what an emergency fund is, it is simply the money you save up to have on hand in case an emergency need pops up. The money is usually held in cash, as it is liquid and easily accessible if needed.
This fund would be for situations such as:
- Losing your job
- Major health/dental expense
- Major Home/Car repairs
- Emergency Pet Care
- Unexpected travel (think family emergencies)
These are just a few examples as there are many other unexpected expenses that an emergency fund could help cover.
What most Finance experts disagree on is how big this emergency fund should be.
Usually, it’s based in terms of how many months’ worth of expenses it can cover. I’ve seen advice ranging from 3 months, to 6 months, even as high as 8 months worth of expenses.
Most recommendations advise a range of 3-6 months worth of expenses with the choice ultimately depending on the risk level of the individual person.
More risky people may prefer a smaller emergency fund so that they can invest the rest of their money. On the other side, more conservative people may have bigger emergency funds to ensure they are covered for any scenario that may occur.
For the first couple years of my working career, I was on the conservative side… until I realized what that was costing me.
My Story
Along with beginning contributions to my 401K, one of the first pieces of financial advice I received when I began working was to start an emergency fund.
I worked into my budget that each month I would put $250 into my primary Savings account (Emergency Fund). In addition, I would put all tax returns, year-end bonuses/achievement awards and any extra paychecks (my company pays bi-weekly so twice per year I would get a third paycheck in a month) towards the account as well.
I was more on the conservative side, so I honestly did not even have a number in mind of where I wanted to get to. I figured the more money in there, the better (which is true! but to an extent).
Thus, my savings went on autopilot, and I rarely paid attention to it, other than noting how big it was getting!
Eventually, by the end of December 2016, I had nearly $30K total in cash. Wow! I have mixed emotions here.
On the one hand I’m very happy I was dedicated enough to stick with and achieve my savings goal. On the second hand, what was I thinking!? There’s no way I needed that much cash on hand!
I’m a young, healthy person with a very stable job. The likelihood that I would be fired from my company, even in a market downturn is very low.
By keeping all that money in Cash, I was missing out on both tax savings as well as an incredible bull market. And it has cost me at least $10K.
The Math
I wanted to keep it very simple with my math here:
In 2015, I only put in about $6K to my 401K, while in 2016 I put in a little below $8K.
At the end of 2015, I had about $18K in cash, while at the end of 2016 I had about $30K.
My new risk level on the Emergency Fund has me feeling most comfortable with around $10K in Cash, though plus or minus a couple thousand is not a big deal.
Therefore, say in both 2015 and 2016 I had instead put $10K each year into my 401K. My 401K returned about 10% in both 2016 and the first half of 2017 (midway through 2017 I invested that money in a Roth IRA and Brokerage account).
The $10K contributed in 2015 would’ve gained about $1K in 2016. Then also would’ve gained another $1K throughout the first half of 2017.
The $10K contributed in 2016 would’ve grown by slightly less than 10% (due to timing of contributions) in 2016 say by $500. That too would’ve gained another $1K throughout the first half of 2017.
Right there alone I missed out on nearly $4K in investment returns!
The other side of this is that by not contributing that money into my 401K, I missed out on the tax savings. I’m in the 25% tax bracket, plus another 4-5% in state taxes.
By lowering my taxable income by $10K, I could’ve saved nearly $3K in taxes each year!
Total that all up and I’ve missed out on about $10K in the past two years!
This doesn’t even consider taking the $3K in tax savings each year and investing that further.
In Summary
Seeing this is so frustrating. If only I had thought about how much I really needed in my emergency fund, I could be in a much better situation!
Now, I realize that my current emergency fund is definitely on the low end. For many people this would be too risky and they would have peace of mind with more cash on hand.
This is absolutely a decision that needs to be made on an individual level.
I merely wanted to point this out to those that also may have too big of an emergency fund. If you are in a stable job, don’t have any health issues, no kids and/or have a higher tolerance for risk, maybe you can get by with a smaller emergency fund and invest the extra money!
Hopefully this post can help others to realize that in exchange for peace of mind, your emergency fund is actually costing you the potential to grow your money even more.
Let me know your thoughts in the comments!
I’m always looking at my entire stash as my emergency fund, yes we do hold some cash, but it usually it not much and is tailor to the upcoming months in terms of (major) expenses.
Nice post!
Thank you! Agreed, that’s absolutely one way to look at your emergency fund as well. Personally I prefer about 2-3 months worth of expenses so that way I wouldn’t need to sell off any investments at potential inopportune times to cover a major expense.
Thanks for reading!
You make a good point about really thinking through how much is really needed. Too much emergency fund isn’t a common problem but legit point. Holding too much cash can make a huge difference over time.
Agreed! Especially so if like me, someone is forgoing the tax advantages of 401k contributions in order to build one up.
Thanks for reading!
Great post, something to think about for every saver.
I was in a similar position until I came to my senses a few years ago! I had a large sum of cash in a savings account at a local bank earning absolutely nothing. Literally a couple dollars a year given what interest rates are these days. I made the change and put nearly all of that money into investments. Now I keep about 6 months worth of expenses in that savings account. Anything more now goes to my brokerage account.
Thanks Brian!
Yes my savings account is similar with the extremely low interest. That money just essentially gets eaten by inflation every year. But glad you made the change! The more money that’s invested and working for us, the better 😄
You have to keep in mind that the results could have easily gone the other way if the market turned on you. It may seem like it was a bad idea to keep that cash now simply because the market kept soaring. Still, maybe your totals were a bit too high considering you could have put a bit more into your 401k and gotten the tax benefit while still keeping an ample cash hoard on the side.
Agreed, most of the additional returns I would have gotten would’ve came from tax benefits and this was a very short term look for investment returns.
I suppose the general point I was trying to make is that for those carrying a big emergency fund, long term you assume the market will grow 4-7% and you could be missing out on those returns by carrying more than you require in cash for your emergency fund.
One thing I do to try to make sure I get some return on my emergency fund is by keeping them stashed in 5% interest, FDIC insured savings accounts with Netspend and Insight. It does take a little bit of work to set up, but at 5%, it at least means you’re getting a guaranteed return that beats inflation (and really, it’s like bond-like returns, in a way).
Wow that’s a great return for a savings account! That is a great way to get the most out of the emergency fund and making sure it doesn’t get eaten by inflation. I’ve never seen that before so I will definitely need to look into it. Thanks for sharing!
Sometimes I feel like people forget that even though brokerage accounts might not be cash you can get in a second, it’s still accessible if something happens. I keep about 5 months of living expenses in standard savings accounts. In case of an emergency, what are the chances I would need all the savings money at once and then some? Highly unlikely. If something were to happen, we have that money to float us until we can sell investments. It doesn’t take that long for a check to come. Yes, there would be some tax implications but I’m wagering my bets that the chance of needing to dip into investments for an emergency is slim to none and I’d rather take the returns.
Totally agree Laine. As long as someone has extra money in a Brokerage account (not retirement account), it only should take less than a week, or two max to get that money in cash. One could put the emergency expense on a credit card and then immediately pay that off. Also agreed with how unlikely that event would be.
Glad we’re on the same page! 🙂
Well yeah, I’d say you overdid it a little bit 😉 though it’s hard to say that you “saved too much” – just that it was sitting on the sidelines for too long. I’d say your current emergency fund is just right for your situation.
Haha yes that’s why I was conflicted! Definitely happy for saving all that up, but the inevitable “wow I wish I did something with that” thoughts came up. Oh well, you live and you learn, hindsight 20/20 I suppose 🙂
Like I keep saying – better now than at 60!
Great article. I think there is a a definite case for a huge variance in EF sizes. This is an individual issue, as you pointed out. It looks like in your situation you were right to reduce it (invest it).
I’m on the other side of the equation. My wife and I are both in great sales jobs, and we have kids. Our income varies, and our expenses are fixed higher with daycare payments. We’ve ramped out EF up from $10k to $30k as the kids were born. However, after the kids start public school, it’s likely we can invest some of that cash back into higher ROI areas.
Thank you! Yep I totally agree with that approach. Given our situations are drastically different, it makes a lot more sense for you to keep more cash on hand and feel more secure. Just wanted to point out the opportunity cost some people are giving up when they may not necessarily need that much!