Imagine the stock markets are plummeting, your portfolio has incurred a significant unrealized loss and you need a substantial sum of cash immediately. What's your safety net?
Having an emergency fund minimizes the need to sell investments during market downturns. It protects your future profits by keeping your investments intact, allowing them to recover and grow.
It also helps cover expenses if your income stops or decreases, if you need to pay medical bills not covered by insurance, settle taxes, handle auto and home repairs or support family members.
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An emergency fund is a highly liquid, risk-free asset that isn't affected by market volatility. Typically, savings or money market accounts are the best choices because they prioritize protecting your principal over earning interest.
Also, your emergency fund should be hard to access for unnecessary spending and free from withdrawal penalties.
How much to save in an emergency fund
A standard guideline is having enough in savings to cover three to six months of essential expenses. If you are self-employed, have irregular income or support others, aim for the higher end of that range or even more.
Keep it up to date. Review it annually to be sure it still covers your expenses. And if you do dip into it, be sure to replenish it as soon as you can.
How should you build an emergency fund?
Decide on the dollar amount you want to reach eventually, then work toward it gradually, month by month. Here are some suggestions:
- Transfers: Schedule monthly transfers from your investment income, your paycheck if you're still working or your Social Security benefit.
- Non-employment income: Set aside a portion of your freelance earnings.
- Tax refunds and bonuses: Earmark a portion of refunds or bonuses.
- Windfalls: Direct unexpected money gifts or an inheritance.
In short, an emergency fund is the smartest insurance policy you can have. It boosts your confidence by helping you stay calm during market declines, enabling you to make well-informed financial decisions from a position of strength.
Note: This item first appeared in Kiplinger Retirement Report, our popular monthly periodical that covers key concerns of affluent older Americans who are retired or preparing for retirement. Subscribe for retirement advice that's right on the money.