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Financial Literacy 101: How much should you save for emergencies?

Fourth in a series for
Financial Literacy Month

During National Financial Literacy Month, we're featuring a series of posts covering investing and personal-finance basics.

Here's post four — about having a sufficient level of savings for financial emergencies.

Before putting money at risk in the markets, you should first establish a savings reserve. Without savings to turn to during a financial emergency or a period of unemployment, you may end up being forced to sell your long-term investments just to make ends meet. Even worse, you might have to sell at a bad time (i.e., when prices have dropped).

How large should a 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 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 $73,010 in 2008 (the most recent year for which figures are available). Technically, the Census figure is a "median" not an "average," representing the point at which half of all married couples are above this amount and half below (see income table here). But we'll use $73,010 as the "average gross" for purposes of this illustration.

When trying figuring how much to set aside in emergency savings, we're not actually trying to replace gross income, however, but 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 $73,010, we'll subtract an estimated 16% for payroll, federal, and state taxes. This leaves $61,327 in after-tax income, which translates to a need of $5,110 per month.

Of course, in an emergency, some normal spending — for entertainment, vacations, 401(k) 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 ($5,110 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.

SMI's Financial Literacy 101 series

• Creating your own personal financial plan
• Save by paying yourself first
• Where to put your savings
• How much should you save for emergencies?
• The upside of index funds
• A simple and steady investing strategy
• Inside-out investing
• Making the 'right' investing decisions
• Your most important investing decision

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