Buffer/emergency fund - correlation with age and wealth

Question

I am getting out of debt and looking into setting up a small buffer for any possible emergencies before I start investing into stocks etc.

Is there any guideline as to how much of a buffer one should keep, relative to their age and wealth status?

I realize this is a broad question. I am a professional in my late 20s with a salary of about $70k per year. So any advice for my specific situation is welcome, but I would also appreciate a broader look at the recommended approach with regards to different age and wealth groups.

Answer 1

While you are getting out of debt, only a small emergency fund is needed. Raising a larger one delays debt payoff. Since $1,000 covers a majority of emergencies, that is all that is needed at that stage of a game. Now, this is band-aide type fixes and is typically used in conjunction with a "scorched earth" type of debt pay off. That is no spending on leisure , earning extra income, cutting the budget deeply and throwing all extra funds at debt. Typically you go smallest to largest debt, but some prefer the highest interest rate first.

That may be scary for some, but it is to serve as motivation to get out of debt sooner.

So at that stage, if your car needs repair, you do the minimal possible. When I was in this stage, my car's AC went out during the summer. I chose not to have it repaired and I live in a hot climate. If an emergency does happen, then you pause debt payment to rebuild your savings to the $1,000 mark.

Once you are finally out of consumer debt you should shoot for a 3-6 month worth of expenses for an emergency fund. Personally I do 4 months for the several reasons, among them that we have a lot of supplemental sinking funds that can be used to cover emergencies. Also my wife and I both work and either one of us can cover our monthly expenses.

Having a fully funded emergency fund will allow you to invest with impunity and shield you from many economic woes.

The only real factor in calculating a fully funded emergency fund is expenses. Age or income does not matter greatly.

Answer 2

6 months is generally assumed to be decent. Depends on where you live and how good your unemployment insurance situation is whether you can manage with less, but generally 3 months is a first and 6 months a second goal. This is real net living expenses.

Wealth groups really depends. I mean, your income is nice - but if you get wealthy you start getting income for example from rental. Which sort of does offset the need for emergency funds. Depending on where your wealth is, you may also have a lot of liquidity just somewhere around - not only for emergencies, but also because you want cash in case of a surprise chance to make money. There really is no good answer. None which is not too private or too showing offy.

Generally once you have your reserves, start building savings for whatever (retirement comes in). That may include buying YOUR house (or not, some people need mobility more than THOSE savings), but definitely putting money into stocks, real estate that generates income. Depending on your passive income you may replace your personal emergency funds with repair funds- I can live, for example, from my rental income, albeit on a reduced level. But it means I do not really need 6 months living expenses. OTOH sometimes you need repairs/renovations, so there is a property emergency funds. And yes, those do not wait - becuase we talk of rental property. If something needs fixing, it needs fixing.

If you approach retirement or a financially oriented lifestyle, you likely want 3-5 years reserves on the bank. Stock market crashes can be nasty and you don't want to take money out. OTOH if your financial lifestyle is trading.... well. Depends on your career planning.

Answer 3

The answer depends on what types of emergencies you want to protect against.

The most common protection is for loss of income. Typically this means job loss, and in this case you should think about how easy it would be for you to get another job, and how much it would pay. Certain people are in high demand and could have a new similar paying job in 24 hours, whereas others might take 6 months or longer to find similar paying work. Some people are overpaid and know it would be impossible to find a similar paying job. So, first try to honestly assess how long it would take you to find a new job. Second, calculate your expenses needed to cover you during that time. Third, multiply that number by 2 (in case you're wrong and to avoid stress). Lastly, take the higher of your number or 60 days. (I recommend a minimum of 60 days because some companies like to start new hires on a particular day of the month, and then you still may not got paid for at least 3 weeks after your first day.)

If you are protecting against a medical emergency then you should have at least your insurance deductible available in your emergency fund. If you are unlucky enough to be injured while out of work, you should add your deductible to the amount you calculated for job loss above. Note though, that most medical providers will offer some sort of payment plan if you are unable to pay all at once. Even without a payment plan most large medical claims take months to process before you receive the final bill, and this would give you time to plan accordingly. If your insurance plan offers an HSA, I'd recommend trying to build up your balance to be at least your deductible, and if you can afford it I'd recommend maxing out the contributions even if you don't need it (because you can use it as a tax-advantaged retirement account too).

If you can think of other emergencies, factor them in too. Do you have a relative that may be sick or in need of financial assistance, and you know you'll be helping out? Do you have a crazy terrier mix dog that could jump out the window of a moving car and break his leg which could cost $5K to repair? In most cases you don't have to add the totals of every type of emergency into a large number, but certainly be conscious of the fact that more than one emergency type could happen at the same time.

Once you've calculated how much you want to keep in your emergency fund, I highly recommend opening a Roth IRA if you haven't already, and storing your emergency fund there. Make sure that the bank you choose makes it easy for you to take money out of the account (in case of emergency). The reason the Roth works so well is that if you have an emergency you can take any amount you've ever contributed out at any time without penalty. (But not the investment growth beyond your contributions; if you do that then you do pay a penalty.) Once you've withdrawn the money, you may choose to undo the distribution within 60 days without affecting that year's maximum contribution (currently $5500). The best part is, if you don't have an emergency, you can leave it in the Roth and invest it with tax free growth for life. If you can afford it, I'd strive to max out your Roth IRA each year and let it double as your emergency fund. If you have even more money left over, then you can set that aside as your (new) emergency fund so you don't have to touch the Roth.