Past research has confirmed what is intuitive: people who don’t have an emergency fund are much more stressed than those who do, and the more money people have in reserve, the less stressed they are.
This is a reason why Sound Mind Investing regularly reminds readers: before starting to invest, you should
(1) get out of debt—with the possible exception of a reasonable mortgage—and (2) establish an emergency savings reserve. Without the financial foundation provided by these two steps, you may find yourself forced to sell your long-term investments just to make ends meet—and perhaps sell at the worst possible time (i.e., when prices have temporarily fallen).
How much should you save?
Financial planners typically suggest maintaining an emergency fund sufficient to cover three to six months’ worth of essential living expenses. SMI has long recommended a reserve of at least $10,000, but we recognize that one size doesn’t fit all. Let’s run some numbers to see what it would take to cover three- to six-months’ worth of essential living expenses.
According to the U.S. Census Bureau, the median married-couple household income was $76,509 in 2013. The figure we’re interested in, however, is after-tax income. Here’s why: one of the emergencies a savings reserve is designed to cover is the loss of your income. In that situation, you won’t need to replace all of your former income because a certain percentage went to taxes, which you won’t have to pay if you’re not working. So, from the gross of $76,509, we’ll subtract an estimated 16% for payroll and income (federal and state) taxes. This leaves $64,268 in after-tax income, which translates to a need of $5,356 per month.
There are other expenses that could be put on hold or significantly reduced in such a situation as well: entertainment, vacations, discretionary clothing purchases, 401(k) contributions, etc. In broad-brush terms, you could probably cover the essentials with 75% of after-tax income. Therefore, a three-month savings reserve for this typical family would amount to roughly $12,051 ($5,356 x .75 x 3). A six-month reserve would total $24,102.
The table 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). Ideally, 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.
Right about now, you may be feeling like comedian Steve Martin’s character in an old Saturday Night Live skit. Sitting at a kitchen table with his wife while listening to an infomercial announcer talk about buying what you want/need out of savings, he asked, “And where would you get this savings?”
One possible source of funds you could use to jump start an emergency fund is a tax refund. About 80% of taxpayers get a federal refund each year, and the average amount tops $3,000. If you typically get a refund, commit right now to putting your next one into a savings account. Then, consider having your withholding adjusted so less money is taken out of your paychecks, and use the added cash flow to continue building your emergency fund. (To estimate how much you should have withheld from your paycheck, use the IRS withholding calculator.)
Ultimately, the target size of your savings reserve will depend to some degree on how many “breakable” moving parts your life has. A single person who rents an apartment and has a fairly secure job will need less than a married person who has kids and owns a home.
Your emergency fund isn’t for getting new tires or an annual furnace check-up. Those items should be covered by budgeting a certain amount each month for vehicle and home maintenance and repairs. An emergency fund is for bigger-ticket expenses, such as a major repair that you had no way of anticipating. And as mentioned earlier, the biggest financial emergency for most people would be a sudden loss of income.
It’s best to keep your emergency savings where it can earn at least a little interest while remaining easily accessible. This isn’t stock-market money or real-estate money. Today, one of the best options is an online bank. Such banks are FDIC-insured and typically pay a higher interest rate than brick and mortar banks.
A well-funded emergency fund will help protect you from the financial storms of life, and knowing it’s there will go a long way toward helping you sleep well at night.