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.
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.
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.
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!