In the continuation on our series on savings, we discuss the factors that influence how much you should keep in your emergency fund!
Join us as we discuss what questions you should ask yourself before deciding how much savings is enough, and the downside of keeping too much in cash!
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] It is crucially important for high income earners to have in emergency reserves when needed, but it's also important that they understand exactly how much they should keep in their emergency fund and when they should start diverting their cash to other financial goals. Let's get started.
Hi, my name is Brenton Harrison of New Money, new Problems, and your host for the New Money New Problems podcast. We're in the midst of a few episodes where we're talking about the importance of establishing an emergency fund and things in your finances that you should do on the way to establishing a minimally acceptable amount of reserves.
In the first episode in this series, we talked about how really all other financial goals should cease if you cannot call on at least one month's expenses in the event of an emergency. In the last episode, we talked about when you should get to the minimally acceptable level as a high income earner of establishing at least three months expenses saved.
But during that journey, from [00:01:00] one month to three months, you may decide to venture out a little and start paying a little extra on some of your other expenses if you so choose. Although my preference would be that you hold off until you've met that level. But in this process, we have never actually defined what Brenton considers a true emergency fund because it may be a little different than what you've heard in the past.
To me, an emergency fund is an amount of money that you keep at zero market risk and can be called upon in case of an emergency. Now, zero market or zero economic risk functionally means that that money is in cash. That's what I consider an emergency fund, an amount of money you've determined you need to call upon if the road gets rough that has no possibility of losing money in the market, no possibility of being taken away. Even though inflation may eat away at its purchasing power, you know it's there and the exact amount you put aside can be called upon when you withdraw.
[00:02:00] I give you that definition because in the previous episode I also shared that I am not the type of person to keep a tremendously high amount of money in cash reserves or an emergency fund. But there is a huge distinction between the amount of money I keep in cash in an emergency fund and the amount of money that I have access to.
And in sharing that difference, I have to introduce you to a term called qualified assets and non-qualified assets.
Qualified assets are things like your 401K or certain other retirement accounts.
These tools have a number of restrictions as to how much you can contribute when you can access them without penalty, but in exchange for those restrictions, there are a number of benefits.
In some cases you get a tax deduction when you put the money in and others, you get a tax benefit when you take money out. And in many qualified accounts, it is tax deferred, meaning that as your money grows, you do not owe taxes on that growth [00:03:00] from year to year.
A non-qualified asset is an asset that does not have as many restrictions. You can put as much money as you want to in these accounts, there are not as many restrictions as to when you access the funds without penalty, and in exchange for that flexibility, they are taxable. So a non-qualified account is not a retirement account, it's a fund or an investment or a type of tool that you can access at any point in exchange for paying taxes on certain things like the growth from year to year dividends and a number of other investment activities that we'll be discussing at length as this podcast carries on.
I tie that definition of a non-qualified asset to the difference between an emergency fund and the funds to which I have access, because while I do not keep a tremendous amount of cash in an emergency fund, it is crucially important for me, especially as an entrepreneur, that I do have [00:04:00] assets that are growing and can be accessed at any point in time. That is the difference. I do not like having a certain amount of money in cash because cash does not give me the opportunity to see my money working for me.
But I also wanna make sure that as I fund my business, that as my family has needs that in a pinch I can access some of those non-qualified assets if doing so will further our financial success or enhance our financial security.
As a fee-based financial advisor, and there are several different types of financial advisors, I earn money a number of different ways throughout the course of the year. And because that can change from one year to the next, or even from one month to the next, I do not have a guarantee of what I earn month to month.
Now, by this stage in my career, it has leveled out. I have certain minimum expectations where unless I just get up and do absolutely nothing for the day, I know I'm gonna make at least a certain amount of money. But I [00:05:00] also, early in my career, had days and months and years where it was a wildly different amount that I earned from one period to the next.
And that can be very difficult if you're trying to manage finances while also trying to build your business.
As a result, the emergency fund that I keep is not just for emergencies, like the blown tires that we've discussed. It's also for periods where my income fluctuates.
And as such, that is how my reserve typically functions. It is something that serves to level out my income during periods of volatility.
Thankfully, however, by this stage in my career, if I'm doing what I'm supposed to be doing, that period of volatility should not last more than three months or so. I also am married to a person who has a more stable income than I do. She works as a W2 employee, and her job and her career is stable.
So between the two of us, knowing that in my situation, it's unlikely that I would go a [00:06:00] period of longer than a few months with extremely volatile income, and with her situation, knowing that her income is also dependable and stable, I do not feel the need to keep more than three months expenses in pure cash.
Keeping money in cash beyond those three months for my household, which is an important distinction for my household, puts those dollars in a place where they lose their utility, which is a word that I come back to frequently, because to me it's very important when you evaluate where you're going to put your dollars, that you think about where they have their highest and best use, where they have their most utility.
And as a business owner, I want to make sure as much as possible that my dollars are working for me when I'm not working.
I've come to this conclusion after a number of years, not only working with other people in their finances, but also a number of years navigating financial life as a couple with the person that I share my life with. A number of [00:07:00] years evaluating the way that our expenses have changed when we were a young couple, moved to a not as young couple. Then moved into parents of a young child, and if those needs shift over time, so will the amount of our emergency fund.
It's all about you having an idea of the factors that inform the amount of money that you should keep in cash. And after the break, we'll talk about what some of those factors are and why Three months for me may mean six months for you or 12 months for someone in a different situation.
Before the break, we talked about the factors that influenced the amount of money that my family keeps in emergency reserves, and I also intimated that for each person or for each household, it's gonna be different.
So I want to talk about some of the different questions you can ask yourself to help determine the amount of money that's appropriate for you to keep in cash.
First is how stable is your income, but also how stable is your occupation? There's so many different jobs out there where you can make crazy [00:08:00] money over the course of 12 months, but that does not mean that you make that money divided by 12, and it comes in the same amount every single month.
You might be a commercial realtor, a residential realtor. You might be in sales, you might be in an organization that gives large bonuses based on performance metrics that you don't necessarily control. All of that plays a role in you determining whether three months or six months or a year is appropriate for you.
If you're watching the news, you're seeing tech workers laid off by the thousands, and we could be entering into a period where it could be more difficult for these people to find jobs that were comparable to what they were earning before.
That might mean that for a period of time, they should be more focused on the amount they keep in cash than in times past.
If you're in a relationship and you have a partner or a spouse, the dependability of their job matters as well.
If I was married to a tenured professor at a local university, there's likely not going to be [00:09:00] a scenario where I have to call upon a year's worth of expenses in my cash reserves. They're never going to get fired.
But conversely, if I'm partnered with someone who's a stylist at Nordstrom, it could be helpful to have more in reserves during the slow months when you're not getting those same holiday commissions like you are at the end of the year.
The common rule of thumb for an individual who has an extremely dependable job like a physician, although depending on your specialty, that can change as well, or a couple that has pretty dependable jobs would be three months expenses. But remember as well that a rule of thumb is typically something that somebody just made up a long time ago, and after enough people repeated it, it became a rule of thumb.
So you have to have this conversation for yourself. If you are in an occupation where as an individual it's not sturdy, or even as a couple, you have two less than stable professions, then six months may be helpful because not only can [00:10:00] it cover periods of unemployment, it can also cover any other emergencies that might pop up while you're unemployed.
The next question, how is your health? If you have a family? How is your family's health? Are you going to the doctor frequently? Are there a number of different medications that you have to take?
Do you have something that necessitates you seeing a medical specialist?
For all of these reasons, you have to ask yourself about your health status and also look at things like your health insurance, deductibles, and other insurances like your homeowner's insurance deductible.
All of the factors that influence the insurance associated with your person and your property should be assessed before determining your number.
I'm filming this after a unique week of emergencies for my family .
Just last Sunday, we found out that a faulty water pipe was leaking water from the second floor of our house that eventually made its way into the living room on the first floor of our home, we had to file a homeowner's insurance claim and had to pay a $2,000 deductible to make sure [00:11:00] that it was fixed.
On Thursday of last week, my son, who's asthmatic had a cough. That cough was restricting his breathing to the point that we spent the entire Thursday night and most of Friday morning in the emergency room, and we have yet to receive that bill. But I say that to say, if this were also a period of volatile income, it is guaranteed that we would have to dip into those emergency reserves to cover those expenses.
You don't know what the emergency is going to be because if you did, it wouldn't be an emergency.
Next, what are your debts and what are the interest rates on those debts? This brings us back to the conversation about utility. I cannot tell you the number of times that I've sat across the table from an individual or a couple who has six months expenses saved, and 15, $20,000 in credit card debt , and they keep that amount on their credit card because they just can't seem to let go of the money that they have in cash. But they haven't had to touch the money in that emergency account in five or six years. [00:12:00] Does that mean you liquidate all of those funds and draw your reserves down to zero to pay off your debts?
But what would be the point of keeping that money there as compared to having $40,000 in reserves and knowing that you have no debt on that card growing at a rate of interest?
So if you've been sitting through these last couple episodes talking about how to establish an emergency fund, wondering when we're gonna get to the stuff that's relevant to you, because you have plenty of money in cash.
You need to also ask yourself, do you have plenty of consumer debt as well?
And lastly, do you have a large upcoming purchase? I'm talking about you're trying to buy an investment property or buy your primary residence. Maybe you're considering buying a car in cash because you don't want a car loan. If it's something that's an extremely large purchase, you definitely want to know that the amount of money you put aside will be there when you need it.
Brenton: And less than a year out from that purchase, the potential risk of you investing those [00:13:00] funds and seeing a loss that impacts your ability to make that purchase probably outweighs any gains that you would make in a given market year.
As an example, if you have $50,000 that you put aside for a down payment on a property, a 10% gain in that investment would be $55,000. I know you're not turning down $5,000, but a 10% loss that brings you down to 45,000 could be the difference between you closing on a loan or not.
So in periods like this, it could be very helpful to go way above what I say as my preferred emergency reserve, or even your typical preferred emergency reserve to ensure those funds are there when it's time to make that splash payment.
Now, let's say you have all these things in place and you've been had 'em in place. I know that's not grammatically accurate, but you know what I mean. You have a stable job. Your health is fine. You don't have any large upcoming purchases, and your debts are under control [00:14:00] yet, you still find yourself holding on to six months, nine months, a year, two years worth of expenses in cash.
Now we have to ask ourself the question, is there a financial reason that you have this much in cash? Or is there an emotional reason that is keeping you from putting that money to work for your own benefit?
I can't answer that question for you, but it's partly why we've talked about in our earlier episodes, money disorders, the things we bring with us from childhood that impact how we treat our finances today. And you in your journey of figuring out how much is too much need to be honest about how you feel about your money, about how certain financial experiences make you feel, and how they inform what you think is appropriate. Because you can reach the point of diminishing returns where having too much money in cash instead of giving you the comfort that you might be looking for, could be making it more difficult to be as secure as you need to be financially.
So go forth, have those conversations, ask those questions. And [00:15:00] in the next episode, we'll talk about once you've found your number, how to make sure that after you've reached it, you continue progressing financially.