Emergency Funds: Why Everyone – Even High-Income Earners – Should Have One
There’s a Reason so Many Experts Recommend this Safety Net
We’ve all heard the prevailing wisdom that everyone should have an emergency fund, but is it necessary for physicians, lawyers, and other high-income earners? This is a bit of a divisive question, with some financial experts continuing to push the dogma of having a cash reserve of at least three months’ salary set aside somewhere, and others making a sophisticated argument that an emergency fund doesn’t truly serve high-income earners.
It’s true that not every person’s financial needs are the same, but it’s still important for everyone to build and maintain an emergency fund regardless of income or assets.
Wherever you are in your career and financial journey, having a cash reserve set aside for a rainy day serves three important purposes.
An Emergency Fund Helps You Exercise Your Personal Finance Muscles
Knowing and understanding basic personal finance concepts is great, but it’s the act of putting them into practice that truly impacts your money mindset and helps you solidify positive financial habits and grow your net worth. The act of building an emergency fund and learning to be disciplined about saving can be difficult, so setting a goal to save three to six months of expenses – as many experts recommend – provides helpful structure and guidance.
Access to Cash Saves You Money in the Long Run
The practical application of an emergency fund is fairly elementary: If you have an unexpected medical bill, car repair, or broken appliance in your home, it saves you from taking on more debt through credit cards or high-interest personal loans. Even if you feel you have plenty of assets available to cover needed expenses, consider that having cash at your disposal ear-marked for unexpected expenses saves you from potentially having to liquidate assets at a loss or sell investments in a down market. In short, it can end up saving you money in the long run by ensuring you can still “buy low and sell high” at your discretion.
A Cash Reserve is Foundational to Your Money Mindset
When you know you have a cash reserve available in the event of an emergency, your money mindset can evolve in important ways. Having a safety net allows you to take on more risk in other areas of your financial life. For instance, you could save on insurance premiums by raising all of your deductibles. On the career front, a cash cushion can help you cover expenses if you want to find a new position, start a business, or if you are laid-off. Furthermore, the psychological backstop an emergency fund provides can calm your anxiety in a bear market because you’ll know you have months’ worth of expenses socked away just in case you need it.
Future Earnings and Borrowing are NOT an Emergency Fund
One of the common arguments made against emergency funds is that they aren’t necessary if you have a steady paycheck and a credit card. In this scenario, it is often said, you can charge whatever unexpected expenses you need to on your credit card, then pay the balance down with your next paycheck before you pay any interest.
There are quite a few problems with this. First, if you need emergency cash because you lose your job, this plan goes out the window and you end up with credit card debt. Second, there may be times in life when more than one thing goes wrong at once. For instance, if you become injured or disabled and you can’t work, not only will you lose your paycheck, but you’ll also have unexpected medical bills. In a situation like this, it is better to have a cash reserve to rely on.
Your Health Savings Account is NOT an Emergency Fund
It’s not unusual to wonder whether your Health Savings Account (HSA) should be part of your emergency fund, especially if you’re in the habit of fully funding it. The concern with relying on an HSA, of course, is that those dollars can only be used for one type of emergency unless you’re willing to pay taxes and penalties on withdrawals.
Where Should You Keep Your Emergency Fund?
A common question regarding emergency funds is where to keep the money, and the answer varies depending upon your preferences. Some people keep some cash on hand and several months’ worth of expenses in a checking or money market account. Some choose to keep the entirety of their emergency money in a high-yield savings account, and some people prefer short-term, high-quality bond funds. In truth, your best bet is to utilize multiple options at once. Whatever you choose, remember that the idea is to have easy access to your emergency fund so that you can avoid liquidating assets or selling investments at a loss if you need cash quickly.
Beware the Opportunity Cost
Although there are many benefits to keeping an emergency fund, it is good to keep in mind that safe investments don’t earn you much. There will always be an opportunity cost associated with maintaining easily accessible cash reserves. If you’re lucky, you might be earning one percent interest on it (less than inflation). In comparison, if you invest those same dollars in real estate or equities, you have the potential to earn much more. Furthermore, every dollar you keep in the safety of an emergency fund is a dollar you’re not putting into a tax-advantaged retirement account. Not only will you miss out on compound interest, but you won’t be able to take advantage of tax-deferred and tax-free opportunities either. Keeping these opportunity costs in mind can help you decide how much you’re willing to set aside for your emergency fund.
Final Thoughts on Why Everyone Should Have an Emergency Fund
Emergency funds play an important role in your financial security and, although they do have a few downsides, the benefits are clear. If you’ve been thinking that your high income exempts you from the need for cash reserves, it may be time to reconsider that mindset and begin building your emergency fund today.
Speaking with a professional financial advisor about how best to allocate your savings, investments, retirement savings and cash reserves could help you optimize your returns and minimize your tax liability. Please contact us today for a complimentary financial consultation.
Paces Ferry Wealth Advisors, LLC is a registered investment advisor with the U.S. Securities and Exchange Commission (“SEC”). This material is intended for informational purposes only. It should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney or tax advisor.