An emergency fund, or better yet, as we like to call it an “uncertainty fund” is a liquid cash account that could be accessed very quickly in the event of an emergency. Typically emergency funds are held in a money market or savings account. Establishing an emergency fund is an important first step when it comes to managing your personal finances. Everyone should have one, however many have a hard time trying to figure out how much they need. To help illustrate my point, do a quick internet search to see the variety of opinions as to how much money is needed in an emergency fund. Even professional financial commentators like Dave Ramsey and Suzie Orman differ on the question of how much you need to set aside in an emergency fund. Instead of joining in on the debate of how much you should have set aside for an emergency, let’s just say we agree with the premise that everyone needs one. How should you determine how much you need? That is precisely the question that I hope to help you answer. Below are 3 important tips that I hope will help you come up with a plan that will fit your unique situation. Good luck and happy reading!
1) Listen to your “inner voice” if you have a specific number you need to see to feel comfortable:
Dealing with money can sometimes be a very emotional task. Some people like it and some people do not. In our practice, when it comes to creating an emergency fund, one of the first questions we ask is what amount of money do you need to see in a no risk, liquid account to feel safe? It is a very personal question and is usually a starting point for us. The answers to this question can vary greatly. Some are very confident in their investing abilities or feel like somehow they are immune to emergencies. Typically for those folks we need to remind them about the various uncertainties in life that are beyond their control. On the other hand, we have had some clients that prefer to keep a very, very large sum of cash in a no risk type of account. In that situation, we remind them that there is such a thing as too much in an emergency fund. After all in today’s very low interest rate world they may be sacrificing too much potential return for safety.
2) Consider your personal situation:
It is very important to consider your own unique situation when trying to decide how much you need in an emergency fund because everyone’s situation is different. Consider your employment situation – how secure do you feel about your job income? Look at your family – if you are married, does your spouse work? Do you have kids? If you own your home, think about the age and replacement cost of things like your air conditioner, furnace, various appliances, etc. Ask yourself the question, if the furnace when out today, how would I pay for it? Last, but certainly not least, consider your current health/dental/vision insurance situation. Obviously you cannot control whether you or someone in your family will get very sick. What is your deductible (look at family deductible if you have kids)? Review your family maximum out of pocket. Do you have enough set aside to cover the deductible and maximum out of pocket expense if you or a family member got really sick? Healthcare is a true wild card and its potential cost must be closely considered when establishing an emergency fund.
3) Do not (I repeat) do not get greedy:
Here is what I mean when I say do not get greedy. When it comes to the emergency fund, it is simple, do not risk it. The minimum emergency fund balance should be held in a FDIC insured bank account, that has no principal risk. Accept the fact that the emergency fund is not investible. Yes, it is likely you will be giving up the potential for greater returns by not investing it, but at least you know it will be there when you need it. I personally like online banks that have saving or money market accounts currently (as of 2/27/17) paying close to 1%. When searching for a bank for your emergency fund, I suggest you start with an institution that you already do business with, like perhaps your credit card company. Oftentimes credit card companies, like American Express and Discover offer what they call high yield savings and money market accounts. You might also look into options at a local credit union if you prefer the idea of having the ability to visit a local branch. Regardless of where you choose to have the fund, keep it safe.
We have had some great questions from clients this month. Below are three that we thought were worthy to share.
1) I have both a SEP IRA and a Traditional IRA, should I combine them into one?
More often than not, the likely the answer will be yes. A SEP IRA and a Traditional IRA will both function as an IRA . The main difference between the two is a SEP IRA is able to receive employer contributions in addition to regular personal contributions, while a Traditional IRA can only receive personal contributions. The extra contribution ability afforded by a SEP IRA gives it a sizeable advantage over a Traditional IRA as a much larger amount could potentially be contributed to it each year. Typically small business owners, or employees of small businesses are the folks that would opt for a SEP IRA. If you already have both, we would suggest combining your Traditional into your SEP (the SEP being the account that survives), especially if you ever expect to be in a position to receive an employer contribution in the future. If you have a specific reason to have multiple IRA accounts, like different beneficiary designations or for the tracking of investments you may want to keep them separate. If not, combining them could make things easier. The less moving parts the better.
2) My tax preparer said that I owe capital gain taxes related to a mutual fund capital gain distribution in 2016. How could that be, I did not even sell the fund in 2016?
A capital gain distribution is a taxable distribution received as a shareholder of a mutual fund based on the fund’s activity for that year. It is suffice to say that capital gain distributions are annoying. All funds are required to pass through the capital gains that were realized in that year to shareholders before the end of the year. These come in the form of distributions. Not all funds pay capital gain distributions. Prior to buying a fund, it is helpful to look at items like, portfolio turnover or what percentage of the fund’s assets have unrealized gains to get a better idea if the fund has a potential for future capital gain distributions. Additionally, the investment research firm, Morningstar, publishes a tax cost ratio which measures the impact that taxes have had on a particular fund’s historical performance. It is important to consider the tax impact of any investment prior to purchase. After all, it is not what you make, it is what you get to keep that really matters.
3) I am required to take a minimum distribution from my IRA this year, when should I take it?
We would suggest that if you do not need the money now it would be best to delay taking the distribution until later in the year, preferably the last quarter. The benefit of waiting is it gives you more time for your money to have the ability to continue to work for you tax deferred. Many securities, like stocks and bonds, pay interest or dividends throughout the year. If you take your required distribution in January instead of December, you essentially give up almost a year’s worth of tax deferral potential. Regardless of when you take your RMD, just make sure you do take it before the end of the year. The penalty is egregious at 50% of the required distribution not taken.
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