The Emergency Savings Rule of Thumb

“A smart man only believes half of what he hears, a wise man knows which half.” – Jeff Cooper

On with breaking our most common financial rules of thumb. In financial planning, the emergency savings rule of thumb often gets the most broadly applied and that’s not a good thing. Here’s the rule.

You should have an emergency fund of at least 3-6 months of household expenses.

First, let’s define what an emergency fund is not – it’s not a bundle of cash you store in a safe, under your mattress, or in a cookie jar above the fridge.

What an emergency fund IS – a readily accessible account with cash set aside to cover emergency expenses should cash flow ceases or an unexpected need comes up.

How to calculate your need… This is partially rule-based and partially subjective. And each person is radically different. Sadly, the amount people actually keep tucked away is one extreme or another. Either none at all or way too much.

Here are the risks. Don’t have enough, you cash out the wrong investments, wreck tax benefits, push into higher tax brackets or sell hard assets to cover emergency needs. Too much can be just as bad by robbing from your future, giving too much to Uncle Sam and end up victim to the increasing costs of living.

As a financial planner, it’s surprising how often I sit down with people who have several years of expenses saved up, sitting in cash. Time flies, business goes on, and taking the time to set up a financial plan or even a simple investment plan just doesn’t become a priority.

Of the primary things to consider:

  • Job stability – having a stable career means less cash is needed because the future is more certain.
  • Stable income – consistent cash flow reduces the need for cash since more will predictably come in.
  • After tax assets – saving is important. How you save is crucial. The more you have in accessible accounts, the less you need in cash.
  • Credit available – if you carry low credit balances and have high limits, this is accessible in an emergency.

Pretend your job is incredibly stable, your income rarely fluctuates, you have a sizable nest egg in accounts you can spend and you have big lines of credit you rarely use. In this case, I’d say there’s not much reason to have more than a month’s expenses saved. Rarely will you have an emergency that costs you more than a month’s income, and if you do, it’s rarer that you’ll need to get to it the same day.

On the other end, say your job is hit and miss, your income is commission based and you rely on big sales that happen once every year or two. You have no invested assets and your credit is unavailable. I would say that 18 months is probably not enough for you and that you should save as your life depends on it. Because it does.

There are many more aspects we can go into – such as age, risk tolerance, income level, location, potential emergencies etc. Each has its own influence on how much you should have in cash.

Your emergency savings is a crucial piece of your financial plan and it shouldn’t just be paid lip service. There is a balance. Holding too much is bad. Holding too little is worse. We’re happy to discuss with you the best amount for your family or business. Please call Ryan Forster at 913.681.9155 or email ryan@engageadvisors.com for more info.

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