How Much Emergency Savings
Do You Really Need?
By Mark Biller with Joseph Slife
© Sound Mind Investing | January 2009
The recent one-two punch of a stock market swoon with a surge in unemployment has reinforced advice SMI has offered many times: before putting money at risk in the markets, you should (1) get out of debt and (2) establish an emergency savings reserve.
Without the financial foundation provided by these two steps, you can find yourself forced to sell your long-term investments just to make ends meet—and sell at the worst time (i.e., when prices have dropped).
Since SMI's Level 2 is about "saving for future needs," we'll focus here on the savings component of that financial foundation.
How large should your savings reserve be? Financial planners generally recommend an amount equivalent to three-to-six months' living expenses. SMI has long suggested a reserve of at least $10,000, but we recognize that one size doesn't fit all.
Let's run the numbers. According to the U.S Census Bureau, the average "married-couple family" had a gross income of $72,785 in 2007. (See table here. NOTE: We've actually used the "median" figure rather than the "average". The median represents the point at which half of all married couples are above this amount and half below.) For purposes of this exercise, we're not really interested in gross income, however, but in after-tax income.
Here's why: A savings reserve is designed to cover living expenses in the event of a loss of income. You won't need to replace your total income because a certain percentage of your gross goes to taxes — taxes you won't have to pay if you're unemployed.
So from the gross of $72,785, we'll subtract an estimated 16% for payroll, federal, and state taxes. This leaves $61,139 in after-tax income, which translates to a need of $5,095 per month.
Of course, in an emergency, some normal spending — for entertainment, vacations, 401k contributions, etc. — can be postponed. As a result, we've estimated that only 75% of normal spendable income would need to be replaced from savings in the event of a financial emergency.
Therefore, a three-month savings reserve for this typical family would amount to roughly $11,500 ($5,095 x 75% x 3). A six-month reserve would total $23,000.
The table below shows target amounts for three- and six-month savings reserves at various income levels. 
You can see that the $10,000 "rule of thumb" is a good initial target for a three-month cushion, but depending on where you fall on the chart, you might want to go higher or lower (but not too much lower). Actually, it's better to prepare for longer than three months.
(For the table, we used a uniform 16% estimate for the amount of gross income consumed by taxes. Those with lower incomes should use a smaller percentage; those with higher incomes will need to use a larger percentage.)
It's wise to keep at least two month's worth of your emergency savings in a money market mutual fund or a bank money market account, so you can access it quickly if the need arises. Beyond that it's okay to branch out into conservative bond investments. But recognize that if you need all your savings at once, you might have to sell your bond funds while prices are down.
Ultimately, the target size of your savings reserve will depend to some degree on your lifestyle and preference. Just don't make the mistake of thinking the need for a well-funded emergency reserve doesn't apply to you. 
 |
Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds. |
 |
Former SMI staffer Joseph Slife is now the senior producer and co-host of The World & Everything in It, a weekly radio program produced by WORLD magazine that can be heard here. He spent 15 years with Crown Financial Ministries, co-writing articles with Larry Burkett and serving as executive producer for broadcasting. |
RELATED ARTICLES
MESSAGE BOARDS
|
