I have noticed over the years that clients that have financial peace of mind also have is to sufficient liquidity or cash on hand/emergency funds. Having these funds available helps me and others feel a greater sense of abundance. It helps cover the financial chaos of life and the ability to pay for life as it happens with much less financial stress. That is financial peace of mind.
Often the common suggestion for emergency funds is three to six months of living expenses set aside in case there is job loss or some other income loss such from a disability. While anything put away for a raining day is helpful. I take a different position, a position that is common to the methodology of the fee-only planners of The Alliance of Comprehensive Planners (ACP). This philosophy is so fundamental that it is one the first steps for young folks right out of school. This helps folks get financial grounding for life. There are two parts to this financial peace solution.
I recommend that the average person or couple has 10% of their annual income in cash equivalents for the ebbs and flows of life. This percentage can vary depending upon employment status. The self-employed (20%), retired (30%), or unemployed (40%) need to have higher amounts because their financial situations are likely riskier. Those higher numbers can be a stretch, but most people can achieve them over time. Think of this as the “under the mattress” money. This money helps when there are one or more surprise expenses that pop up. Having the cash means not having to put them on credit card or other high interest loan. The 10% amount is much more achievable than three to six months of income. Yet, in a pinch the 10% amount can usually cover two months of living expenses.
A typical financial emergency definition is a large surprise expenditure or loss of income. ACP and I define emergency as drop in tax bracket (likely a result of loss of income). That is because there is true financial emergency when income unexpectedly drops enough to be in lower tax bracket.
Emergency funds are equal to the greater of double the amount discussed above or 20% of the home mortgage balance. This can provide a safeguard during a prolonged period of lost income.
I get it that this additional set aside money is hard to achieve when combined the earlier mentioned cash need. At minimum this amounts to 30% of one’s annual income.
There is a hack that makes this more manageable for many folks. The trick is that these funds can do double duty. You can use 401K or IRA or other similar tax deferred retirement accounts to hold this money. My clients save for retirement at work, get their employer’s match, and count these funds as their emergency funds. Now that doesn’t mean the retirement account becomes an ATM spitting out cash as needed. Rather a portion of the account is set aside to function as the Emergency Fund. Otherwise the account functions for traditional retirement planning that hands off until retirement. This hack works because the drop in tax bracket offsets the 10% early distribution penalty on the tax return making it relatively tax neutral solution.
How to Store Cash and Emergency Funds
I believe it is essential to keep the monies in cash or cash equivalents. For me, this means for accounts that have maturity dates like Certificates of Deposit and Bond Funds that mature (come due) in 18 months or less. Types of accounts that I recommend include Certificates of Deposit, Ultra Short-Term Bond Funds, Money Market Accounts, and Savings Accounts. There is usually an option that works within 401K and other similar retirement plans. Using a bank account normally provides FDIC insurance as a safeguard against loss.
There won’t be a lot of growth in these accounts and that is simply fine. The purpose of these funds is to have them available on a rainy day and not at subject to whims of the stock market or other risks. Safety and availability supersede yield. I like having my Cash Needs money in a type of account where there is no tax consequence for withdrawals such as a bank savings account.
Funding these accounts can be a simple as setting a specific savings account at your bank or taking part in your workplace retirement plan. Most folks find it is easiest at first to automatically transfer a small amount each pay period. After a few pay periods, these same people find room in their finances to increase it a bit more. It can take time for the snowball effect to take place with these accounts. That is to see the accounts grow and take on a greater and greater influence on having financial peace.
I know. I have worked this process and set up such accounts for myself I found it financially settling as have my clients. Knowing I had not created my situation overnight, I was patient and allowed the system to work. Over time, these funds created an increasing level of financial peace as I knew I had funds available to weather the financial storms of life.