The partial shutdown of the federal government provided the latest example of why an emergency fund should be among the top financial priorities for every household.
Would you be able to pay the bills on time if your paycheck disappeared for a week or two? How about for a month or two?
Would an unexpected major car repair create hardship?
I know it’s very hard for most people to set money away for emergencies. But “emergencies” have become pretty regular occurrences lately, and most of the alternatives to having an emergency fund are bad choices.
Payday and title loans may count as funds in an emergency, but that’s not the same as having emergency funds. Racking up debt on high-interest credit cards isn’t much better.
The good news is that if you have assets such as a retirement fund or a home, you may have more of an emergency fund than you realize. It depends on how your finances are arranged.
The goal for an emergency fund — typical suggestions are three to six months’ salary — is likely out of reach for most people, but any savings are good savings.
If you haven’t started saving, begin with small amounts, then just keep going and don’t look back. Eventually, even small deposits will add up.
If you have assets, the key is making sure you can tap them in times of crisis without paying penalties.
Recession, job loss, health problems, divorce, crime and natural disasters are just some of the things that can plunge a person or family into a financial emergency. And these things are happening regularly to someone, somewhere.
Of course, there are also government and employer furloughs to worry about. And then there are the unexpected “black swan” events.
Who thought back in 2007 that global demand for mortgage-backed securities would prompt lenders to write home loans to anyone with a pulse, creating a house of cards that caused a historic international recession?
Talk about an emergency! Countless people who had no role in the housing bubble lost jobs and homes as the economy contracted and real estate values plunged.
Recessions and other economic emergencies are the times when people of modest means are often forced to sell what little assets they have at reduced prices, while those with piles of cash swoop in for the bargains. Just look at the large percentage of residential properties that even now are being purchased in all-cash deals — more than half of all sales nationwide, several studies claim.
You may not aspire to be one of the folks who swoop in with piles of cash to buy depressed assets, but I’m sure you don’t want to be the person forced to sell depressed assets.
So, what to do?
Look at the options
The first step, if you haven’t done this already, is to get a firm hold on your financial situation. Know your assets and your debts, your interest rates and loan terms. Find out your ability to get at the value in your assets if you had to.
For example, I recently spoke with a woman who owns her home free and clear, but may have to sell it to avoid losing it because of unpaid taxes. It seems she has bad credit, so she can’t tap into her home equity, and became disabled, so she can’t work.
That’s a great illustration of why it’s a bad idea to focus on paying off your mortgage, unless you have a large emergency fund built up as well. In times of crisis, you may not be able to tap all that equity in your home.
Home equity lines of credit provide one way of tapping home equity when needed, but as many folks discovered, banks can decide to reduce those lines of credit at the most inconvenient times, as many did during the Great Recession. Plus, that line of credit is a loan, or, put another way, another loan payment.
The most straightforward place to keep emergency funds is in a bank account, separate from your other accounts. You won’t earn much interest, but the money’s safe, federally insured, and easy to withdraw if you need it.
A separate account with an online bank, linked to your regular account electronically, is a good way to keep emergency savings out of sight, and you could set up small automatic transfers from your regular bank account to grow those savings over time.
Retirement savings certainly count, when you’re thinking about whether you have an emergency fund. Ideally, you don’t want to dig into money meant for your retirement, but in a financial crisis, it’s a potential source of funds.
Retirement savings including IRAs and 401k plans can be accessed, but not without paperwork and possible penalties. For example, a withdrawal from a traditional tax-deductible IRA or a 401k plan before age 591/2 is both taxable and subject to a 10 percent penalty unless IRS-approved conditions are met.
There are ways to avoid the 10 percent penalty — see IRS Publication 590 — but because of the complexity and paperwork, a traditional IRA is a last resort for emergency funds. A 401(k) withdrawal would additionally involve your employer, and the need to demonstrate “immediate and heavy financial need.”
A Roth IRA, on the other hand, allows you to withdraw the amount of money you contributed without fee or penalty. That’s because you paid taxes on the money before contributing it. Any earnings on the money would be taxed and subject to early-withdrawal penalties, but those funds could be left in the Roth account.
Loaning yourself money from a 401k plan is an option many plans offer, but that also has pitfalls, the largest of which is that you could have to repay the entire loan immediately, or face a tax bill plus penalties, if you lost the job associated with that account. That would be a bitter pill for someone already in a financial crisis.