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How Much Emergency Fund Do I Need?


Military people know: Murphy can strike at any time. Cars stop working. You might need to buy an emergency plane ticket somewhere on short notice. Your spouse could lose her job. And, of course, there could be a military pay snafu.

In the civilian sector, a layoff can come at any time. Or you could be falsely accused of something that costs you your job. That steady paycheck you get from working can come to a screeching halt at any time, for reasons beyond your control.

For military families, no-notice layoffs are pretty rare. If military life has anything going for it, it’s the fact that you can usually rely on that steady paycheck.

But even that paycheck can get slashed, if the government thinks you owe them money. (Ask anyone who’s commanded a company with a lot of equipment for any period of time and they’ll tell you about that.) DFAS can cut your income by up to 50 percent until the debt is paid off.

No matter who you are, you need some emergency cash in the bank to deal with life’s events.

How much you need depends on your circumstances. But Thomas Jensen, a financial planner in Portland, California, thinks people should shoot for about six months’ expenses in easily-accessible cash, in the bank, and maybe up to a year.

There’s no substitute for cash.

Chronic Unemployment

The economy continues to struggle. The chronic unemployment rate is as high as it has ever been in recent memory. That means people who are unemployed tend to stay unemployed – for months or years. According to the Bureau of Labor Statistics, there are more than 5.3 million people who have been unemployed for 27 weeks or longer.

The November 2012 jobs report from the BLS indicates that 56.4 percent of unemployed workers remain unemployed for over 15 weeks. And 41.3 percent of workers who are out of a job remain unemployed for at least 27 weeks.

That’s a problem. Unless Congress strikes a deal to extend unemployment benefits again, unemployment insurance will revert back to the 27-week benchmark. That’s not long enough for 4 in 10 workers to find a job.

Now, math geeks will understand the significance of these numbers: The Bureau of Labor Statistics does not tabulate job search or unemployment lengths beyond 27 weeks. The median length of unemployment is 19 weeks. That means that exactly half of the unemployed find work in less than 19 weeks, and the other half take longer than 19 weeks.

But the mean number is weighted by how long the longer searches take. And the mean average is 41.3 weeks.

That means a lot of job searches are taking significantly longer than 41.3 weeks – enough to turn the mean distribution to a number more than twice the median.

That is a very ugly number – and it indicates that the traditional advice to keep three to six months income needs in the bank was inadequate. The real number is income needs for somewhere closer to a year.

The unemployment numbers are particularly tough on military spouses, because the frequent moves make it very difficult for them to find new employment, when employers expect them to leave town in a couple of years or less – taking all that experience and investment in training with them.

Where Should You Keep Your Emergency Fund?

The most important things to keep in mind for money earmarked for your emergency fund are safety and liquidity.

Your emergency fund should not be subject to risk – either because the market fell, or because someone takes it away from you.

This is why relying on credit to bail you out of the next emergency is a bad idea: Chances are good that your credit lines will be revoked just when you need them most.

The second principle is liquidity. That means that you should be able to turn your emergency fund into cash in hand – easily exchangeable for goods and services – quickly and easily. That means relying on being able to sell your boat or your real estate to raise cash isn’t appropriate for an emergency fund. In order to sell it quickly, you might have to hold a fire sale and sell the assets for a fraction of their real worth.

That’s not what you want to do.

Accounts

The easiest place to keep an emergency fund is in a bank checking or savings account. I would suggest segregating your emergency fund money into a separate account, though, to protect it from impulse purchases and to help prevent a case of identity theft from zeroing out your bank account and emergency fund at the same time.

Yes, banks generally return your money if you are the victim of identity theft or fraud on your account. But that can take time, and the greater the amount of money involved, the longer the bank may drag its heels on crediting you back.

The advantage to keeping your emergency fund in a bank checking or savings account is chiefly convenience, and FDIC protection. If the bank becomes insolvent, the Federal Deposit Insurance Corporation will guarantee your principal, up to $250,000 per account holder. If you choose to use a credit union rather than a bank, you still get the same protection, but from the Credit Union National Association, rather than the FDIC.

The downside of keeping your emergency fund in savings and checking accounts is that the money earns next to no interest for you. As of this writing, interest-bearing checking accounts were sporting yields of 0.53 percent according to Bankrate.com.

CDs

If you want to eke out a bit more interest, you can use a certificate of deposit, or CD. These still get you FDIC or CUNA protection, and a hair more interest. You do lose a bit of liquidity – the bank will typically charge you six months’ interest if you pull your money out before the CD matures. But you can “ladder” CDs so they expire every month or two, if you have enough money to spread around.

Money Markets

A money market is simply a mutual fund designed not to lose money. The downside is that they never make much, either. But they make a little bit, and they are time-honored places to stash cash that you want to earn a bit of interest on without taking any market risk. According to Bankrate.com, the average interest rate on money market funds for account balances larger than $25,000 is 0.67 percent. You’ll make a bit less than that if your account size is smaller.

Note: There’s no FDIC protection on these. They are not contractually guaranteed not to lose money. It just rarely happens because they focus on very stable securities like short-term government debt and very short-term high-quality corporate debt that rarely defaults. Occasionally they’ll drop below the 1 dollar per share benchmark. Historically, when they do that, the fund company dumps in enough cash to keep things at a buck a share rather than take the PR black eye. But there’s no guarantee they will always do this.

Life insurance

Cash value life insurance has a long track record of being a great source of emergency cash. Make sure it’s a whole-life policy, or a universal life policy that you can afford to throw in a bunch of extra money at it. My preference is for dividend-paying whole life insurance policies from a mutual life insurance company – meaning that the company is owned by its policyholders rather than by stockholders.

While term life insurance policies expire worthless when the term expires, whole life policies are designed to pay a benefit no matter when you die. Premiums are higher, but that’s because the payout is a sure thing, rather than a maybe. Your eventual death is a pretty safe bet. Because your eventual death is certain, the insurance company has to set aside significant cash reserves over time to have money available to pay your death benefit. This money accumulates tax free, and you can borrow against it for emergencies or whatever else you need.

It’s a safe bet for the life insurance company, because if you never pay back the loan, they’ll just take it out of the death benefit they pay to your beneficiaries.

Whole life cash value is contractually guaranteed not to lose money, and contractually guaranteed to increase every year.

The downside with these policies is that it takes time to build them up. They are “front-loaded” financial products – meaning that the bulk of the expenses and commissions are paid in the first year, so you are “underwater” for a while before your cash value catches up to the total premiums you’ve paid. The agent can show you an illustration that will project what your cash value will be worth when. These are excellent products, but they are more for someone with a long-term time horizon who wants or needs a permanent death benefit in addition to term insurance.

These are not really a great spot for your emergency fund if you cannot dump significant amounts into the policy, over and above the minimum. For the best results at cash value accumulation, get a relatively small permanent death benefit with a larger amount of term insurance tacked on as a rider. This allows you to pour more money into the policy and let cash value build up faster.

Bad Places for your Emergency Fund

Credit cards

Available credit does not count as an emergency fund. It is brutally expensive when you use it – cash advances charge much more interest, normally, than purchases do. And your access to credit has a way of disappearing just when you really need it. Don’t rely on credit cards, or on anyone else to lend you money.

Retirement funds

Some retirement funds, such as some 403(b)s and some 401(k)s won’t even let you access the money in an emergency, anyway. If you do, be prepared to pay a 10 percent early withdrawal fee if you are under age 59½. There’s an exception for those who are aged 55 who have already left the work force.

More than that, though – if you raid your retirement fund for emergency cash, it’s tough to put it back in, because the law limits IRA contributions to $5,000 per year – if you qualify at all. Your balance might never recover from a raid for emergency funds. Meanwhile, you are taking money growing tax-free (Roths) or tax-deferred (traditional IRAs, SEPs, SIMPLEs, 401(k)s), and turning it into a taxable asset. And while you’re spending it on emergencies, it’s not going to generate much investment return for you

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