Covering Your Assets With an Emergency Fund

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When things are going well, we tend to believe they will always go well. We're employed, our careers are progressing, and life will always be this good -- right? And then something finally goes wrong, and we start making bad decisions that cost us far more than the money we should have been setting aside specifically for emergencies.

This lack of perspective is the reason more people don't have rainy-day funds. One common excuse for neglecting to establish an emergency fund is, "I don't need an emergency fund because I can fall back on _____." Sure, we all have ways of getting through a rough patch -- but they generally come at a high price.

The consensus among financial advisors is that your emergency fund should be at least three to six times your monthly expenses -- and ideally equal to your net income for three to six months. Having this amount in reserve ensures that you will be able to cover your living expenses in a worst-case scenario. 

From the frying pan into the fire
There are problems with each of those "blanks" that people often resort to in lieu of an actual emergency fund. Lacking liquidity, people often turn to credit in hard times. The problem is that credit costs money, and depending on when trouble strikes, it can be incredibly expensive -- if it's available at all. You could end up having to borrow money at 25% or 30% just to pay bills.

Tapping into retirement accounts is another common substitute to having a rainy-day fund. Setting aside the fact that money withdrawn prematurely from retirement accounts is seldom replaced in full, there are other consequences. Withdrawals or loans from traditional 401(k)s and IRAs trigger 10% penalties and have tax consequences that can potentially cost additional thousands of dollars, resulting in cash shortfalls when you can least afford them.

There's also the option of selling of stocks or bonds to raise emergency funds. While stocks and bonds generally appreciate in value over the long term, on any given day their value can be lower than your original investment -- not to mention that selling means missing out on potential future gains.

Where to stash your rainy-day money?
By now I hope you realize that the best way to prepare for emergencies is to set aside money specifically for unexpected hard times. Rainy-day funds, like other investments, should have growth potential, so stashing your cash under the floorboards in your closet is not the way to go. Day-to-day savings, money market funds, and short-term CDs are the most liquid. But are there are alternatives to these low-yield vehicles?

One great option is the Roth IRA, which allows tax- and penalty-free withdrawals of your contributions because it is funded by post-tax income (earnings are taxable until you reach 59-1/2 years of age). So if at any time you need to withdraw some of your original investment to pay for an emergency, you can. And if an emergency never arises, the funds will continue to grow and become a source of retirement income.

An often overlooked way to save for an emergency is a universal life insurance policy that also provides for your survivors in the event of your death. This type of insurance uses premiums to purchase permanent term insurance and build a cash reserve that earns interest at a variable rate based on the amount accumulated with a minimum guaranteed rate of return usually equal to a savings account.

Whichever method you choose, reaching your goal is like driving from New York to Los Angeles: It may seem a daunting distance, but you'll never get there if you don't get started. Putting away just 5% of your monthly net income will build a three-month emergency fund in only five years. For example, if your monthly income is $3,000, your goal may be to save a three-month reserve of $9,000. By saving $150 per month, you'll reach your goal in five years.

The need to accumulate a fistful of Benjamins for a rainy day was best summed up by Benjamin Franklin himself: "Failing to plan is planning to fail."

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 26, 2015, at 3:32 PM, coffeedoc1 wrote:

    I designate the excess cash value in my blended whole life insurance policies to be my emergency fund. I can have the money sent to me in 5 business days (any more urgent need can be floated on a credit card until the Insurance check arrives and then paid off before interest accrues). If the emergency is of a short term nature, I can take the insurance money as a loan to be paid back after the emergency has passed (with a differential interest rate of only 0.7% between what the insurance company charges me and what they pay me on the cash value in my policy). If the emergency is permanent, I can take the money out of the policy as a withdrawal, which lowers the total death benefit but does not have to be paid back. Meanwhile, the cash value in my policy can never go down with the market and earns 3.5% per year, year in and year out while I am not having emergencies - beats any bank savings account or CD and even beats the safety and returns of most bond funds or even the dividend funds mentioned above (which yield less than 3.5% and can go down with market fluctuations.) Safe, secure, liquid and has the added advantage of providing death benefit to my family. In my opinion it is the perfect place to hold emergency fund money. coffeedoc1

  • Report this Comment On July 26, 2015, at 3:36 PM, coffeedoc1 wrote:

    There is another way for "people subject to income limits to get the benefits of this retirement vehicle," or at least one very like it. Stashing cash as overpaid premium in a blended cash value life insurance policy actually functions very similarly to a Roth IRA. Contributions to the policy are made after taxes and grow tax free within the policy. The money stored as cash value cannot be invested in the market, but does act as good alternative to bonds for the fixed income portion of your portfolio, with returns of 6-7% per year and no risk of your principle to the vagaries of the market. The money can be withdrawn at any time (you do not have to wait until age 59.5) and the withdrawal does not trigger a taxable event - as long as you have not exceeded your contribution limits (which run in the $50,000-$100,000+/yr range rather than the $5,500-$6,500/yr cap placed on Roth contributions). Withdrawals are made on a FIFO basis and do not have to be reported as income (it's like taking money out of your own savings account). The cash value in the policy can be used to supplement your retirement income from SS and other taxable vehicles like 401K, 403b, pensions or traditional IRAs, and any money left in the policy when your retirement "ends" is left to your heirs as the remaining death benefit of the policy. The policy cash value can also be used in the years prior to entering retirement to finance kids' college educations, weddings, cars, etc. and can serve as the "emergency fund" money that we all should have squirreled away (but frequently don't). A properly designed cash value life insurance policy is a good solution to a number of financial problems and can be a very beneficial portion of your retirement planning strategy. coffeedoc1

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