About the Author
David Fulton is a Colorado Springs, CO fee-only financial planner providing Hourly and On-Going Financial Planning and Investment Management. While he works with a broad range of clients, David specializes in working with Active and Retired Military, Federal Employees, and Families with Special Needs Children.
Want to work with David? Get Started⟶
When our son was having his first seizures, we desperately wanted to know the cause. It was not so much academic in terms of understanding the physiology behind it, rather it was emotional. Our baby was perfect…except that he wasn’t, and we needed to know why. We thought we had good insurance and a neurologist we trusted. So when he determined it was difficult for him to give a definitive diagnosis without genetic testing, we wholeheartedly agreed to pursue it. However, what I didn’t know was that it would be a 3 month fight with our insurer and we would ultimately lose. So we did what any other parent would do in such desperate circumstances. We spent thousands of dollars out of our own pocket for the testing. A decision we don’t regret in the slightest, but one that put a dent in our financial life. Fortunately, we had saved diligently and had an emergency fund built for just such a scenario. We weathered the storm, but it easily could have been a significant emotional event.
Why an Emergency Fund?
Our scenario is not that different from any other family. Unforecasted expenses affect everyone. The Pew Charitable Trust conducted a survey and found over 60% of surveyed families experienced a financial shock in the preceding 12 months. The median cost was $2000 which led to more than 50% of the families reporting they struggled to “make ends meet.” Some families faced over $10,000 and 96 days of emergency spending. Scenarios such as unforeseen car problems, identity theft, getting cut work hours or getting laid off, an injury preventing work, a faulty appliance, or a leaky roof can contribute to a financial shock.
I used my example to highlight the additional burden facing families with special needs. In a recent study over 32% of special needs families reported they had either cut work hours, or stopped work altogether in order to take care of their special needs child. Reduced income, coupled with variable medical costs and co-pays, creates the perfect storm for a fiscal emergency. Special Needs Families especially have a savings imperative.
The standard rule of thumb for an emergency fund is 3-6 months of expenses. To identify your expenses you first need to create a budget! Family budgets typically have five different categories; mandatory deductions (taxes, child support); fixed costs (rent, utilities, insurance premiums); medical costs (known co-pays, therapies, durable medical equipment); variables costs (food, entertainment, clothing); and savings (retirement, college). For the purposes of determining an appropriately sized emergency fund, only count the first 3 categories as an expense. Those things must be funded regardless of circumstances, or failure to do so will lead to significant hardship for your family.
Once you add those expenses up and multiply by 3 or 6 I would suspect the total number is pretty shocking. For most people that will account for thousands and thousands of dollars. For the typical American household that is approximately $23,000 to be precise. That is no small amount for most families. Because it is a rule of thumb, it will not apply equally to everyone. The amount you need to save should be informed by circumstances of your employment. For example, those in government service or the military have a stable source of income and can hedge against not getting laid off and in turn may save less. Those who do contract or seasonal work probably need to increase their savings cushion. Those who have saved heavily for their retirement or other purchase (eg a house down payment) or have more than one source of income, may be able to take more risk than those who have saved very little and have limited reserves.
The good news is you don’t have to get there overnight. If you budget properly and build your emergency fund savings into your budget before your variable and lifestyle expenses, you can build up to it over time. However, the challenges with emergency savings are twofold. First the money must be accessible. It can’t be tied up in an investment that is difficult to liquidate, or worse, puts you in a severe disadvantage if the market drops. The second problem, is the harmful effect of inflation on cash reserves.
The Danger of Inflation
Inflation is the rising price of goods and services overtime coupled with a reduction in the purchasing power of your money. As a result, you won’t be able to purchase as much with your dollar. We can all remember how cheap things seemed when we were children. Remember when vending machines only charged 50 cents for a can of Coke?
How this affects you and your family, is that if you stick your savings into your savings account at the bank, you actually lose money year after year. Say you saved diligently and put $1000 into your savings account. The average annual percentage rate (APR) for a savings account is currently .09 percent. That means each year your $1000 of hard earned cash earns a measly 90 cents. Now take into account inflation. The U.S. has experienced and average rate of inflation in the U.S. of 3.22%. That means inflation reduces your $1000 emergency fund by $3.22 each year. Your $1000 can now only purchase $996.78 worth of car repair parts. It may not seem like a lot, but what if instead of $1000, you saved the entire recommended $23,000. At 3.22% inflation your $23,000 would lose $740.60 in purchasing power each year. Yikes!
The Need for Liquidity
So we can all agree inflation stinks…but access or liquidity matters too. This brings us to the second problem with saving for an emergency. The money needs to be there for you during the emergency…duh! We all want to beat inflation. So say instead of putting your money in a savings account, you invest it wisely in a low cost index fund. Great choice. Say your index fund returns you an average of 7%. You would beat inflation by 3.78%. Your $23,000 just grew $869! Unless of course the emergency happens during a down market, like from 1929-1932, or 1940-1942, or 1973-1974, or 2008….you get the idea. In 2008, the market lost 37% of its value. If you liquidated your $23,000 in savings for a true emergency that year you would only have had $14,490 available. The unpredictable nature of our emergencies is the true danger of using stocks for your emergency fund. Liquidity matters; you need to have ALL of your funds available when it counts and not when it is convenient.
I recommend actually creating two buckets for emergencies. The first is an emergency fund for true short term emergencies such as car or house repairs or a trip to the emergency room, this is a raining day fund. You can dip into the emergency fund to pay for the repair or medical bill and then work to pay back the savings over time without incurring credit card debt. The second is what I call the downpour fund. The downpour fund is for extreme and detrimental events such as losing a job or an extended hospitalization for you or your special needs child that will sap your savings over a prolonged period of time. The reason I break these funds apart is because of the type of savings vehicles available and the required access or liquidity.
The Rainy Day Fund; Liquidity is key
The Rainy Day Fund, can consist of a few thousand dollars. The aforementioned Pew Charitable Trust survey indicated most family emergencies cost $2000. That is probably a good number to aim for intially. The point of this Fund is to have cash readily available. Liquidity takes primacy over preservation of capital. You can expect to lose the inflation fight with this fund because you want to have access to it at a moment’s notice. This fund provides you flexibility.
Savings Vehicles for the Rainy Day Fund:
Savings account: You likely already have one established. You can get them through your local bank or Credit Union. Average APR: .09%
- Pro: the most liquid; you can access it anytime
- Con: very limited returns
Money Market Account: Usually provided by your brokerage account; A money market account is an interest-bearing account that typically pays a higher interest rate than a savings account. Average APR: .18%
- Pro: liquid, earns more interest than a savings account; FDIC insured
- Con: may require a higher balance
High Yield Savings Accounts: Usually provided by online banking institutions that do not have local branches, High Yield Savings Accounts provide probably the best mix of liquidity and asset preservation. Some rates are as high as 1.75% APR.
- Pro: earns the most interest of any savings account; FDIC insured
- Con: limited transactions authorized; online access only
The Downpour Fund; Preservation is key
The Downpour Fund is for true long term emergencies. The likelihood of you needing it is significantly less than your Rainy Day Fund. However, if you do find yourself in a scenario that you need to tap into your Downpour Fund, you will be glad you had it. Because you will not likely touch this bucket of money, you can take some risk with liquidity. It is assumed you will only touch this fund when you have spent your existing cash and emergency reserves. Therefore you will want to protect the Downpour Fund from inflation. It can be tied up in assets that are less liquid than cash, but not as unpredictable as the stock market. You simply want to beat inflation, or at least limit its effect.
Savings Vehicles for the Downpour Fund:
Treasury Bills: T-bills are great for short term investments. They are generally safe because they are backed by the U.S. Government, they earn more than your savings accounts, and they are relatively liquid because they are held for short terms from a few days up to 52 weeks. You can purchase them at your local bank or credit union or directly from Treasurydirect.gov. T-Bills are typically sold at a discount from the face value. For example, you might pay $980 for a $1,000 bill. When the bill matures you would be paid $1,000. The difference between the purchase price and face value is interest. In this example, you gained 2% for only a short period of time. Usually the longer the maturity period, the better the returns. You can go over to Treasurydirect.gov to see some recent returns. As of this post the returns range from 1.9% on a 4 week note to 2.4% on a 52 week note. You can also buy a combination of short and long duration notes to maximize your liquidity.
- Pro: Safe, flexible, predictable, and interest is exempt from state and local taxes
- Con: low returns compared to other vehicles, must mature before receiving any interest
Certificates of Deposit: CDs are a promissory note issued by a bank and are similar to savings accounts but require your money be untouched for a set term. Like a T-bill, the longer term you have, the more interest you’ll earn. When the CD matures, the entire amount of principal, as well as earned interest, is available for withdrawal. If you withdraw any principal before the end of the term you’ll generally need to pay a penalty typically between 3 and 6 months of interest. Because of the penalty many people build a CD ladder to maximize returns while retaining liquidity and limiting the penalty. Instead of putting all of your principal in one CD your principal is spread across multiple CDs thereby creating a ladder effect. A CD ladder consists of a series of CDs that are a mix of short term and long term maturity dates. Short term CDs have lower returns, but become available sooner. Long term CDs consequently have larger returns. When one matures it is rolled over and renewed. For example, you might hold a 1 year, 2 year, 3 year, 4 year, and 5 year CD each. Once your 1 year CD has matured, you essentially roll those funds into a new 5 year CD, and your 2 year CD now only has a year remaining until maturity thereby making it your new 1 year CD. This keeps your ladder staggered and keeps you earning higher rates while still giving you access to the shorter term CDs. If there is a real emergency, you simply take the penalty and withdraw early, but still keep the remaining CDs earning interest. Ally Bank has a nice calculator tool that lays this concept out here and depicted in the graphic below.
- Pro: earns higher returns than most other vehicles
- Con: If you redeem before the maturity period you incur a penalty on interest.
I-Bonds: I Savings Bonds are a low-risk savings vehicle that earns interest while protecting you from inflation. Similar to T-Bills, I-Bonds are sold at face value.
What makes I-Bonds so powerful is that the U.S. Government is essentially guaranteeing your principal will not lose purchasing power and will keep up with inflation. Each month your bond will earn interest equal to the initial fixed rate you purchased it at PLUS the annualized rate of inflation during the preceding six months. Nothing else replicates what an I-Bond does. Furthermore, because I-Bonds are held by the Federal Government, they are exempt from state and local taxes, while growing tax deferred; meaning you only owe taxes on the interest when they are redeemed so you are compounding interest on the principal and interest! The downside of an I-Bond is that you only have immediate access to the cash after an initial holding period of one year from the date of purchase. Additionally like a CD there is an early withdrawal penalty of 3 months of interest if you need the money within the first five years of the purchase date. Another benefit to I-Bonds, is if used for an education expense, then the interest is not taxed! Not necessarily a relevant point for an emergency fund, but certainly important when looking at college savings options. I-Bonds can be held for up to 30 years. The return is calculated using a composite rate and is a combination of a fixed rate and the inflation rate. While the fixed rate does not change the inflation rate usually changes every six months. See the graphic from Treasurydirect.gov as an example of how the return is calculated.
- Pro: Savings will never be out paced by inflation
- Con: Cannot redeem for 1 year. If redeemed in the first 5 years incur a penalty of 3 months interest.
Roth IRA: While typically used as a tool for retirement savings, a Roth IRA is surprisingly liquid. You can withdraw contributions anytime. Investment earnings must remain in your account until you’re 59.5 if you want to avoid paying a 10% penalty. You are allowed to do this because you have already paid taxes on your contributions from your payroll taxes. For example, if you invested $10,000 in your Roth, and it grew to $12,000 over time, you should only withdraw up to $10,000 otherwise you will get hit with a tax bill and pay the 10% penalty on the remaining $2,000 of investment income. However, Roth’s can be tricky because they are usually invested somewhat aggressively in a mix of stocks and bonds and are subject to the whims of the market as discussed above. For it to work as a true emergency fund, then a portion of your Roth should be invested much more conservatively. Another downside is that since you are an astute investor, you know about the power of compound interest and the time value of money. As of the writing of this blog an individual is only able to invest $5500 a year in their Roth. By liquidating your principle, you are taking the wind out of your retirement sails, and never get that opportunity back.
- Pro: has the potential to earn the largest return
- Con: prone to market conditions, impacts your retirement savings
What's Best For You?
It's a personal preference on what you are comfortable with and what rates you can get to maximize your returns while also maintaining your flexibility and liquidity. At any rate, having a dedicated savings goal to fill up your emergency fund is imperative in allowing you to survive the inevitable financial downpour.