Our saving plan should cover three essential areas: cash on hand for unexpected bills, money put aside to cover expenses in case our income is interrupted, and an account for later in life when we stop working or work in a reduced capacity. This approach protects our longer term savings from an unexpected withdrawal by providing for short-term financial needs.
The first saving area, which I call the cushion account, contains an amount that we set aside for cash-on-hand to cover things like replacing a broken appliance or an unexpected car repair. Even if we use a credit card in these situations, the cushion account allows us to pay the balance in full when the bill arrives. This keeps us from adding short-term debt or paying interest on a credit card balance. The amount in this cushion account could be $2,000, $3,000, or even $5,000 depending on our feelings about the amount we should have on hand. And since we want the money to be available, a cushion account is usually kept in a regular or money market savings account so we can have easy access to the funds.
The second area of savings or our emergency account, contains an amount that keeps our personal economy going (pays the bills) in a situation when our employment changes. It’s a safety net for our finances if we’re suddenly unemployed or our income is lower for some reason. The amount in this account could be enough to pay for three, six, or even twelve months of expenses depending on our thoughts about our employment picture. These amounts for a person with $2,250 in monthly expenses are shown below.
Emergency Fund Amounts
One Month Three Months Six Months One Year
$2,250 $6,750 $13,500 $27,000
It’s easy to see how quickly we can get into trouble if we don’t have an emergency fund and our income stops for an extended period. Without it, we’ll either start withdrawing from our long term savings (if possible), or start taking on a large amount of debt to keep going. As far as where to keep our emergency fund, the key is our ability to access the money when needed. I think that an insured money market checking account makes sense for most people.
The third area of savings is our long-term or retirement account. This is our IRA, 401(k), or other retirement fund or account that we’ll use to replace income later in life. Referring back to the amounts for the emergency fund above, the amount needed to cover just one year of expenses was $27,000. Consider the amount needed to cover expenses for 30+ years of retirement.
30 Years of $27,000 in annual expenses = $810,000
And this amount doesn’t consider inflation and how expenses will increase each year during retirement. If we factor in a 2% annual inflation rate, the amount needed to cover our expenses in the 30th year of retirement would be just over $49,000 (a $22,000 increase). Calculating each year using the inflation factor changes the total amount needed to cover retirement expenses to $1,095,338.14. Saving this amount is going to require some planning and regular savings (automatic deposits if possible), and no withdrawals. To protect this account, we need money to fall back on when an unexpected expense or change in income occurs. This is where our two lines of defense come in. Our cushion account protects us from withdrawals from our emergency account, which protects us from withdrawals from our long-term savings.
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