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It's Time to Start Putting Money Aside to Grow an Emergency Fund

A sick parent, a home repair or a personal disability could prompt a financial crisis. The amount saved depends on situation.

October 22, 2000|Kathy M. Kristof

Roughly 42 million Americans live paycheck to paycheck, or so says a recent survey commissioned by Automatic Data Processing, a New York-based payroll service. If one paycheck were late, 60% of respondents said they'd have to cut back on at least one important household expense such as buying groceries or paying rent or utility bills, the survey found.

Although ADP says this underscores the need for efficient payroll processing--which, big surprise, happens to be the business ADP is in--financial planners counter that this underscores the need for every American to have an emergency fund. Yet emergency savings have fallen by the wayside in the last decade as Americans have flocked to the better-performing stock market.

"It's things like this that people overlook," says Peg Downey, a certified financial planner with Money Plans in Silver Spring, Md. "[Emergency funds] seem too insignificant or boring, but they are absolutely the key to having a sound financial life."

Would your life be decimated by a financial emergency? It's not difficult to figure out.

"Pretend that tomorrow, for whatever reason, you are not going to be able to work for six months and the stock market is down 15%," suggests Brent Kessel, a certified financial planner with Abacus Wealth Management in Santa Monica. "What would sustain you? Do you have passive income? Would you be able to collect insurance? Do you have bonds that you could sell without taking much of a loss?"

If you feel you could handle a sustained period of unemployment without undue pain or stress, you probably have enough emergency savings, he says. If you couldn't, you need to ask yourself how much you need, how to accumulate it and how to invest this money to keep it available, yet earning a decent net return.

Most people need three to six months of living expenses in emergency savings. (Living expenses generally amount to about half of your gross income, because the other half of what you earn usually gets eaten up in taxes, discretionary spending and savings.) But some people could use substantially more, others substantially less.

The actual amount you need hinges on just how likely you are to suffer sudden economic upheaval and what type of emergency is most likely to strike. Although the very nature of "emergency" indicates something surprising and unplanned, in reality, you can handicap your chance of financial emergency and even come fairly close to hitting the approximate dollar value of the hurt.


The reason is fairly simple. Most people have some economic safety nets, ranging from life, health and property insurance to disability and unemployment coverage. Putting a number on how much emergency money you need, consequently, boils down to figuring just how much cash would come out of your pocket before one of these safety nets kicked in.

If you don't have any safety nets--no insurance of any type or accommodating relatives who would take you in if you couldn't pay your rent--your need for emergency savings is much bigger and more urgent than it would be if you were well-insured and greatly loved by someone with a guest room.

Kessel advises self-employed people and commission-based sales people to consider socking away as much as a year's worth of living expenses to handle prolonged market slumps. Downey thinks half that would do.

"If you are self-employed, you ought to have six months," she says. "If you are just out of school and you have folks who are willing to help you out, you might only need one month. But, for the average American worker, probably three months could do it."

Or, you can simply play a game of "what if," says Edward O'Hara, certified financial planner with Capital Asset Management Services in Silver Spring, Md.

Contemplate the events that could have the most devastating economic impact. Is it the loss of a spouse; the loss of a job; a medical emergency; or even just a big car repair? In the event you suffered one of these catastrophes, do you have insurance to help mitigate the economic damage?

If so, how much of a gap is there between what you'd need and what you'd have? Do you have money in taxable savings accounts--as opposed to retirement accounts, where you'd suffer a huge tax hit for early withdrawals--that could be tapped?

Planners say another economic, and personal, catastrophe has become increasingly common: Your out-of-town parent is ill and needs you to drop everything and help out for a few months. That means losing some income while taking a leave from work and incurring a variety of other expenses, such as last-minute plane fares, Kessel notes.

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