When life happens, it’s reassuring to know that you have some cash stashed away just for emergencies. If you don’t have an emergency fund, however, you’re not alone. According to Bankrate, 24% of Americans have nothing in savings in case of a job loss or an unexpected illness.
An emergency fund can be a financial lifesaver, but it requires a plan for saving. Here’s what you need to know to get your rainy-day fund off the ground.
Calculate Your Target Savings Number
Financial experts generally recommend having three to six months’ worth of expenses in emergency savings, but the amount you’re comfortable with may be different. Or, you may want to have two emergency funds: one to cover smaller expenses like minor car repairs, and a larger one that you could use to put a new roof on your house if needed or pay your bills for a few months if you become unemployed.
Aiming to save at least one month of expenses is a good starting point. Add up all the money you spend each month on the essentials. That includes housing, utilities, gas, insurance, groceries and any other expenses that are must-haves. This number can serve as your baseline for building your emergency fund.
Next, look at your situation and ask what the worst-case scenario would be. If you’re single and you have job security, for example, you may be comfortable keeping just two or three months of expenses in savings. On the other hand, if you’re married with kids and you work in a high-turnover industry or on a consulting basis, you may want to have six months to a year’s worth of expenses squirreled away.
What if you’re working with a smaller income or even living paycheck to paycheck? In that scenario, you may have to set your target a little lower. Saving $1,000 for emergencies, at least to start, can give you a cushion so you don’t have to turn to credit cards or loans right away if something unexpected comes up.
Set Your Plan for Saving
Determining a savings goal for your emergency fund is the easy part. The challenge is saving the money. These four tips can make the process a little easier.
1. Budget for it.
First, take a look at your income and expenses to see how much, if anything, you have left over that you can save each month. Even $10 a month is still something, and if you save consistently it can add up over time.
If you’re not satisfied with the amount that your budget allows you to save, dig in to see what you can reduce or eliminate from your spending. At the same time, consider whether it’s possible to increase your income so you have more money to add to your emergency savings. A side gig or second job might do the trick.
2. Automate it.
For some people, saving money comes naturally, but for others it’s a habit that must be learned. Automating your savings is an easy way to get into the habit and be consistent with growing your emergency fund.
If you get paid via direct deposit, for example, you could opt to have some of your pay routed into your savings account each pay period. Or, you could set up automatic transfers between your checking and savings account each payday. These are simple tweaks that can have a powerful impact on your savings over the long term.
3. Use found money.
If your budget doesn’t allow you to save a ton of money, you can still get ahead by putting anything extra towards your emergency fund. Your tax refund, an annual raise or bonus, rebate checks, cash back rewards from your credit card—those are all examples of found money that you could use to fatten up your emergency savings.
4. Choose the right vehicle.
An emergency fund should ideally be liquid, meaning you can access the money quickly if you need to. At the same time, it’s great if you can earn some interest on what you save. A traditional savings account may be your first choice, but a high-yield savings account or money-market account could offer better interest rates.
A certificate of deposit is another option, but just remember that CDs are locked into a set maturity term. If you have to break into your CD before it matures, the bank will likely penalize you by deducting some of the interest you’ve earned. However, if you’re setting up two emergency funds, as discussed above, a CD is a good place for the larger fund for big emergencies like that new roof.
Using an IRA as an Emergency Fund
If you’ve been saving for retirement in a Traditional or Roth IRA, you may wonder whether those funds can double as emergency savings. While you could tap an IRA early for an emergency, you’ll pay a price. The IRS assesses a 10% early withdrawal penalty on money taken out of a Traditional IRA (or earnings taken out of a Roth IRA) prior to age 59½. You also may be on the hook for paying regular income tax on the withdrawal. And Roth IRAs have five-year rules you need to follow.
The IRS does allow some exceptions to the penalty rule when withdrawals are made for certain reasons. You may be able to avoid the penalty if an early withdrawal is used to:
- Cover homebuying expenses as a first-time buyer
- Pay for health insurance premiums while you’re unemployed
- Cover unreimbursed medical expenses
- Pay qualified education expenses
- Satisfy an IRS tax levy
- Cover your living expenses because you’ve become totally and permanently disabled
That doesn’t mean, however, that you can get out of paying income tax on the money. With a Traditional IRA, early withdrawals would automatically be considered taxable income. With a Roth IRA, the earnings portion of the withdrawal may be taxable, depending on how long your account has been open.
Tax issues aside, taking an early withdrawal from an IRA is not the best choice to cover emergency expenses if you’re focused on growing your nest egg. When you take money out early, it loses its ability to benefit from compound interest. That will shrink your savings over time, and could leave you with a shortfall in retirement. What’s more, you can only contribute $5,500 per year ($6,500 if you are 50 or older), which means you won’t be able to repay yourself beyond the yearly allowance.
Creating a plan for building your emergency fund now and saving regularly can help you avoid having to use the money you’ve earmarked for your later years when a curveball comes your way.