Hey guys, I’m Daniel from Sweating The Big Stuff.
In November, Kevin called me a thief for writing about How to Use Personal Finance to Make Friends. I like Kevin and his songs, but today is my chance to get some revenge and let you know why I think he’s wrong about emergency funds.
Kevin posted on my site today and says Don’t Waste Money on an Emergency Fund, but I think that it’s not a waste, it’s in fact a necessity!
Kevin seems to think that an emergency fund is anything you would be allowed to tap in an extreme emergency. If your choices were between living on the street and paying the rent, is there any doubt you would draw some money from your retirement account to do it?
However, there is a difference between taking action when you’re in a desperate situation and setting up an emergency fund around certain sources. I believe an emergency fund should be a specific savings account dedicated solely to provide money during emergencies. It shouldn’t be kept in a Roth IRA investments, and a credit card certainly isn’t an emergency fund. While these sound inviting and have some advantages, it adds a lot of risk, trouble, and the consequences can be more costly than what meets the eye.
Let’s explore a few different options and see whether or not they are viable options for an emergency fund.
Credit Cards:
The first reason a credit card is not good for an emergency fund because if you ever need to use it, you’ll be going into debt. You don’t have a cushion so instead of paying $5,000 to pay for the emergency, you’ll pay $5,000 plus interest until you can build up enough cash to pay it off. At 25% interest, if it takes a year to pay it off, that’s an extra $1,000 or so in interest, IF you can pay it off in under a year. Paying extra is not a good plan.
Roth IRA:
This plan looks pretty attractive: save in a Roth IRA, and if you ever need to, you can take out all of your contributions (but not the earnings!). With a maximum contribution of $5,000 per year, that could be a nice cushion should you need it, right?
Well there are some major drawbacks to keeping your Roth IRA as your emergency fund. If you’re going to count on the Roth IRA being there, it would be unwise to be as risky as you normally would with retirement investing (what the Roth IRA is meant for!), because a 50% drop in your emergency fund could happen at the same time you are laid off, right? Sounds unlikely? That’s what a lot of people said right before they got laid off when the market tanked.
What source would you tap if a drop in the market led to company layoffs? Would you be prepared?
Also, there is a slippery slope. At what point do you allow yourself to withdraw from the Roth IRA? Is it a disability or a job loss, or should it be used for college expenses, to pay down debt, or for that vacation you wan to take? Are all those things worth taking money out of your retirement fund, risking your long-term savings?
While Kevin suggests some ways to help avoid having to go to the emergency fund, there’s really no way to predict when disaster will strike. There’s no better way to prepare than to getting a low interest savings account, putting 3-6 months worth of expenses there, and just sitting on it. Sure, it’s not too sexy, but you’ll never have to worry about your backup plan and you’ll always have one thing that Kevin won’t: peace of mind.
If you’re in my boat and think a savings account specifically for an emergency fund is a good idea, let me know. If you’re willing to live life on the edge, check out Kevin’s article and let him know you support him. At the end of the week, we’ll add up the comments and see who wins. I’m pretty sure I won the first debate, so let’s keep this streak going!
Looking broader than just the “emergency fund” term, you could have a financial “emergency plan,” including more than just a savings account. If you have access to credit (and are currently not in debt) or a Roth IRA, then those can be a last-resort addition to your plan, but the savings account dedicated for emergencies should be your first defense (after having a few bucks lying around in case you can’t withdraw your money until the next day).
I shared my ideas a few years ago: http://flexo.me/fuVlHm
Like I said, there are always options which everyone would use if it were an emergency, but we can plan around that and keep the cash in that first defense, as you suggest. I don’t have any cash lying around (nor a cool safe to hide it in), but maybe that’s even safer than savings account money.
I may be a bit biased as a staff writer for Daniel, but my part-time boss is right. 😉
An emergency fund shouldn’t be something that will end up making your life even more stressful. It should be cold hard cash that you can literally use to buy a bit of your sanity back.
That said, I’m not a big believer that everyone must have 6 months of expenses or more in cash if they don’t want to, but I’d always suggest at least $5000 or more so little crap that just happens doesn’t lead to high-interest credit card debt or forcing you into selling back investments at a bad time…who wants to be forced to take a major hit because your car needs new tires or you had a small accident or something?
Good girl, lol!
The dollar amount varies based on expenses, but $5,000 would cover about 3 months for me (assuming I cut back a little, which I would in an emergency!) . That’s probably enough, though those are probably some famous last words.
There’s no major hit; you just sell some investments and make the purchase. It doesn’t ruin your finances; it actually makes them better if you sell the investments at a profit!
Yes, but what if you are forced to sell at a loss because you need the money quickly and the market is down? Forced sells are never the way to go.
Hey Daniel. When I first read about Kevin’s version of en e-fund on his 20 milestones post in December, I thought, “hey cool, I have investments (non-retirement) that can count as my e-fund too!” But I just haven’t been able to get past that in my mind, an e-fund is a savings account (as “boring” as that might be). If an emergency situation arises, I don’t think I’d ever consider my savings account (currently sitting at six months of funds with my goal being eight) as a “waste.” Sorry, Kev.
There is something VERY comforting about knowing that should something happen, you’ll be protected. It’s the same idea behind insurance. On average, the insurance companies make money, but guess what? Everyone likes the peace of mind of having that protection.
Gotta agree with Daniel on this one, sorry Kevin. 🙂 An emergency fund needs to be as stable as can be, which commands a special savings account. It’s like saying, would you rather put your emergency food storage out in the sun, or down in a cool dry root cellar? Which is more stable?
That may be going a little far (because what advantage is there to food that’s sitting in the sun? With investments, there’s the opportunity for big gains!), but for an emergency fund, I think stability is all that matters.
Definitely an Emergency Fund fan. My brother lost his job due to the downturn in the housing market (he’s a draftsman engineer for a builder). He was indespensible to the company, which is why he wasn’t fired until it was the boss, the boss’s son and my brother and one more person needed to be let go. An Emergency Fund is meant to be a STABLE fallback fund. It is not meant to “make money”. It is cash insurance for hard times. It is meant to prevent you from reducing future income (retirement), adding to your debt (credit cards) or getting hit with early withdrawel fees or additional taxes at tax time.
Thanks for the insightful vote and comment! The point is that while it’s hard to plan for the unnexpected, you have to because you never really see it coming, no matter your situation.
I’m on this side. Cos when your investment fund bottoms out, and you’re left jobless, you’ll be thankful for that cold hard savings that, due to it’s very little risk, is still there.
Wouldn’t you be even more thankful if your emergency fund was 25% larger than the money you put into it?
That’s why I invest too! I have money coming back as ROI. It’s not my nest egg, but it doesn’t need to be.
I feel like your comment is saying “Wouldn’t you be happier if you had 25% more money or wouldn’t you be happier if your house was 25% bigger. Or wouldn’t you be happier if you could live 25% longer?”
Would you REALLY be happier? Or would you just want more? And if you have to pull that cash out, what is the penalty for doing so? And what happens if you’re hit by a car, and the stock market tanks and you lose your job all at the same time (a FAR stretch, I admit) – wouldn’t you be thankful for having a nest egg somewhere secure?
OR Let’s put it this way: can you tell me the scenario in which your plan of investing is a bad idea? (What’s the flip side of the coin, if you will)
I’m not knocking the idea of investing, but I do think having a certain amount (3-6 months saved) is a pretty prudent thing to have.
Thanks for your response! And for making me think about it. 😉
There’s no penalty in pulling the cash out if you’re in a regular investment account or Roth IRA (as long as it’s just your contributions). You will have to pay capital gains taxes when you file next April for any gains in a regular investment account (or reduce your taxable income with losses).
The flip side of gaining 25% is losing 25%. If your efund was $10,000, then you’d still have $7,500. Less than you wanted, but it’s not like the efund disappeared. Plus, you get to write off those losses on your next years taxes, which could save you up to 33% of your losses, depending on your tax bracket, on your taxes next year.
Also remember that the stock market historically always goes up over time, so your chances are better that you gain money instead of lose money.
I think people are looking at this as if there is a very real chance you’re going to lose everything in your investment. Even through the “Great Recession”, the market only dropped 50% from the absolute peak to the absolute bottom.
Food for thought…
Kevin, I think that your view is very rational. Most people are more risk averse than pure logic would recommend though. So, I think that you are “right” and personally, I’m a fan of your version of the e-fund. However, for many people, the comfort they get from having their e-fund stable in a savings account is valued at higher than the 25% theoretical returns.
I agree that an emergency fund is very important. But I still love you, Kevin!
Love you too! I can disagree with someone and love them at the same time! 🙂
I’m with Daniel on this one. There’s nothing like having the reliability and convenience of having cash available to get out of a jam. Mine is in a short-term bond fund at Vanguard, but it comes with a checkbook that I can use to write for an emergency that comes up or to pay off a credit card that I used in an emergency.
The problem with the Roth idea is that you can’t replenish the account afterward. So your retirement account takes a permanent hit.
The problem with using the CC for emergencies is that if it happens when you have no income, (or expenses exceed income), then what are you going to use for paying the bill when it comes? Plus of course, the interest charges that Daniel talked about. I like having my money work for me, not the other way around.
That’s the point of investing it; so the money does work for you. And for the credit card, if you’re like me they send you checks all the time that can be used as “balance transfers” which are 0% for a year or so. That way you have cash on hand and can use that to make your minimum payments, and spend the rest. Of course, that’s worst case scenario, but it would work.
With regards to the Roth, you may not be able to replenish it, but if you’re not contributing up to the max and you’re just taking money from your savings and putting it there, there’s no downside to taking it out (and not replenishing it).
Even worse: If you’re going to put some emergency savings into retirement, you better not double count it and say you’ve got both an emergency fund and a ton of money saved up. Because then both could blow up fairly quickly.
Kev- my dreaming friend, I hate to admit it- but I’m gonna have to disagree with you on this one. For us, the emergency fund leads to a comfort that only straight up cash, no penalties, no interest, no questions asked can lead to. I hear what your saying about the opportunities to make money off of it in the meantime- but knowing our 6 months worth of un-touched money is there (in case say somethign ends up being wrong with our child and insurance doesn’t cover it) is comfort to keep me going throughout the day and takes one less stress away from marriage 🙂 So in our case- I’m hittin up the low interest 3-6 months savings Emergency fund 🙂
I can’t argue with the comfort position. If it makes you comfortable to keep it, then I guess you’re gonna keep it. I just find more comfort in the 26.85% gain I got in my 401k last year, or the 91% gain I got on some options I sold a few days ago.
I am with Daniel.
1) Emergency funds should be readily available-even a little cash at home re Flexo is good! Most Roth redemption’s take days!
2) the Peace of Mind argument is a strong one, for those who need security
3) People that plan for emergencies are much less likely to have them-and much more likely to have money to invest after they build their fund!
4) The risk of the market or your investments being down, is too closely correlated to emergency fund needs-job losses are closely tied to economy as is the market.
Love the discussion!
Thanks for the support!
I think that #4 is the most important. Being risky is great, but be ready for all the bad stuff to happen at the same time.
As for #3, what’s the big deal about losing $400 a year for peace of mind? Seems like a smart trade-off. You can risk the rest of your money, but not this!
I’m with Dan, having an amergency fund is a personal finance necessity.
I’m not suggesting you don’t have an emergency fund; I’m suggesting you take the money you would put in an emergency fund and get a better return on it. It’s still there if you have an emergency (unless the company you invested in went bankrupt)
I’m with Dan on this one for sure! I would be willing to put it in a high yield savings account, but not an IRA. I’m all for the peace of mind. When I think of preparing for emergencies I don’t want risk involved.