Jonathan Clements of the Wall Street Journal writes a good article that everyone should take a look at and thing about how it applies specifically to their own lives. His advice has solid grounding, but the execution of the advice could be a potential pitfall for some people.
The Popular Advice
As Mr. Clements notes, “some financial experts, your top financial priority should be amassing an emergency reserve equal to six months of living expenses, with this cash tucked away in conservative investments like money-market funds and certificates of deposit.”
Mr. Clements Advice
- Focus on your retirement (401(k), then Roth IRA, then savings)
- Forget about the reserve
- Shelter yourself from taxes
My Short Input
I fully agree with the paths and ideas Mr. Clements takes and find this section of the article to be rock solid. There are circumstances, however, where following Mr. Clements advice can be extremely dangerous.
Why shouldn’t I focus on an emergency stash?
Let’s say you’re great about your spending habits and regularly sock away 10% of your income for a liquid savings account for your emergency funds. Let’s also say your living expenses are roughly $25,000 a year. You would need to save $12,500 to make up your 6 month reserve. If you’re making $50,000 that would take a little more than two years, and if you’re making $30,000 it will take nearly four years.
Why do the numbers seem larger than they really are? I didn’t just do simple division, but took into account savings growth compounding of four percent, a three percent annual raise in income, but also TAXES. Therein lies the key word why you shouldn’t focus on an emergency stash. Taxes.
Chances are if you focus solely on building your emergency stash you’re not contributing anything to a 401(k) nor an IRA of any sort, and that is the key mistake Mr. Clements focuses on. By doing this you are giving up too much of your hard earned money to taxes and potentially losing out on some FREE money.
By contributing to your 401(k) you get the free money your employer gives you as a match. You also lower your taxable income for the year by the amount that you contribute. A Traditional IRA will lower your taxable income as well, but the advantages of a Roth IRA clearly win in the end. You do pay the taxes on the money you put in, but when you take the money out during retirement (this is called a distribution) you pay no taxes on the distribution. That means that any gains and growth the account accumulated gets paid to you tax free! You potentially have hundreds of thousands of dollars in tax free money here.
That’s great but what will I do if I lose my source of income?
There are plenty of reasons that can cause a loss of income and this is the key area to analyze before figuring out how much of your potential retirement money you should sacrifice for the relatively low yield, non-tax advantageous liquid emergency stash.
Can you move in with your parents? If your answer to this is yes, then you have a huge advantage in not needing to save as much for emergencies. Moving back home will provide you a huge sum of money for savings. Notice the key word is CAN. The question is not is it EASY to move back in with your parents. It, likely, will not be easy. You may even have to throw all your stuff in storage and move back to your home state, but it’s something that can save you boatloads of money.
Are you a contract worker or otherwise unstably employed?. An emergency stash is insurance. It’s there should you ever need it, but you may never need it! If you’ve got a pretty stable job (no one can predict layoffs or a sour economy) you probably don’t have to save so much for emergencies. If you know you’ll be without income soon or know that your income isn’t always guaranteed (commission, sales, etc) then you’re going to need a bigger stash.
Do you have other sources of emergency stash? Perhaps your parents gave you a life insurance policy you can borrow against? Maybe you finally lost your source of income a little later in life and your wise decisions allowed you some equity in your home you can borrow against? Even as a last resort you could borrow against your 401(k) after all. Your stash may already be pretty large without it being so obviously cash.
Do you have the urge to spend cash? Be honest with yourself here. If you see cash and spend it, then an emergency stash is a poor choice for you. The point of it being liquid is so you can get access of it quickly and easily. However, if you spend it, you’ve wasted your tax advantage and your stash as well. The other problem is that the cash you sock away is likely to touch your hands first before it gets put away. 401(k)s are taken directly from your paycheck and you never have the temptation to touch the money.
Swallow your pride Sometimes to make a living you have to do something beneath you or a job you don’t really like. If you’re fed up with your job, that’s fine! Find another one, but don’t quit your previous job until you have to. Put up with it just a little longer and it might save you from needing a stash or taking out loans. Also, full time grocery store workers get health benefits (pretty good ones I hear) which may just carry you through.
Change your lifestyle! It’s really amazing how much crap and junk we amass as consumers. Sell off the stuff you don’t need to raise some income and change your spending habits to match your new lower income.
Take advantage of government programs. Make the effort to qualify for as many programs as you can. It may be degrading, but it’s money available to you. Technically it’s YOUR money that you’ve been paying in taxes. That means take advantage of unemployment, disability, Medicaid, food stamps ,COBRA, whatever.
Again, the usual holds true: no advice is one-size-fits-all. Everyone is different and needs to take their own circumstances into consideration before deciding what’s best for them. This includes risk tolerance. If you can stand the risk, by all means live on the dangerous side, but understand your situation and make plans just in case. It’s one thing to live dangerously, it’s a whole other thing to live stupidly. If not having that cash there will cause you insecurity and lost sleep, then by all means make yourself happy.
Your money works for you so you can live life the way you want. You do not work for money. If you ever find yourself working for money, think about what you’re doing. Chances are there is a flaw in your plan somewhere.