A rainy day fund can provide peace of mind and help you avoid financial trouble in a pinch. Most people are familiar with keeping an emergency fund during their working years — however, things may look different after you retire.
Emergency savings are often overlooked, and a retirement emergency fund is an essential piece of a strong financial foundation.
What Is an Emergency Fund?
An emergency fund is an account with cash set aside for unexpected expenses. These expenses may include emergency medical care or a replacement for a broken household appliance. With a solid emergency fund in place, you can quickly address the problem and get things back to normal.
Key Features of an Emergency Fund
Emergency savings should be easily accessible so that you can pay for emergency costs quickly, as waiting often allows things to get worse. If a plumbing or health issue lingers for too long, the consequences and costs could increase over time. It's also best to keep your emergency fund safe in a government-guaranteed bank or credit union account rather than in the stock market. You never know when an emergency will strike — if you have your rainy day fund invested, you may have to sell during a market crash and end up with less money than you need for retirement income.
How Having an Emergency Fund Helps
The primary purpose of an emergency fund is to prevent an unexpected event from causing severe financial consequences. Without any emergency savings, you may need to borrow money, possibly at a high interest rate, or raid your retirement savings. The long-term consequences can reach into other areas, as well. For example, if you don't have enough money to repair something properly, you might have to sacrifice quality or safety for cost, creating an opportunity for the problem to resurface down the road.
How a Retirement Emergency Fund Differs
Emergency funds are critical during your working years. If you lose your job, that money helps you pay bills and avoid debt while you find work. In retirement, since you typically have a steady income from a pension or Social Security, losing income is less of a risk. However, you may still need liquid funds to deal with surprises. For example, during retirement, medical expenses typically increase, and it's crucial to be able to pay for the best available care quickly and painlessly.
How to Build a Solid Emergency Fund
Financial experts typically suggest keeping at least three to six months' worth of expenses in your emergency fund. If you want to be conservative, you can hold even more money in savings. However, there's an opportunity cost to keeping a substantial emergency fund. Assets in safe accounts like savings or money market accounts typically don't earn much, so you may lose purchasing power over the long term due to inflation.
Creating a Savings Strategy
To establish an emergency fund, choose a savings account or money market account that is earmarked for emergency savings. Alternatively, you could open a new account. Either way, keeping that money separate from your day-to-day checking account means you're less likely to accidentally spend it on non-emergencies.
Add money to your emergency fund at a pace that fits your budget. If you get monthly pension or Social Security payments, it's a good idea to schedule an automatic transfer immediately after each payment arrives in your account. Save as much as you can comfortably afford each month, and remember that this is temporary. Once you have a sufficient rainy day fund, you can redirect the monthly savings amount to other areas of your budget.
If you're starting from scratch and you have limited funds to work with, saving $1,000 is an excellent start. Focus on that goal, and take as much time as you need to get there. Then, celebrate your success and continue building up your savings.
Alternative Sources of Funding
You may have other financial assets that can provide funds in an emergency. Although a dedicated emergency fund is ideal because the money is safe and easily accessible, it might not be your only option.
If you have a life insurance policy or long-term care policy with cash value, you might be able to borrow from your policy in an emergency. Doing so could provide a substantial amount of money; however, using an insurance policy for emergency savings comes with several pitfalls. For example, if the policy lapses because you use up the cash value, you could lose coverage and face potential tax consequences. Plus, if you pass away with an outstanding loan balance, the insurance company reduces the death benefit to pay off the loan, impacting your beneficiaries.
Savings held within retirement accounts such as an IRA might also be useful in an emergency. Some people prefer to keep emergency funds invested for the long term in the hopes that the funds will earn more. However, that strategy carries its own risks: If markets are down when you need money, any withdrawals you take will make a bigger dent in your retirement portfolio. As a result, you might spend money that you need for your retirement income.
If you're considering investing outside of bank and credit union accounts, keeping emergency funds in relatively safe investments may make sense. For example, high-quality, short-term bonds are usually not as volatile as the stock market, although it is still possible to lose money with bonds.
Keep in mind that your emergency fund should be separate from any other cash holdings you might have in your retirement portfolio. If you've chosen to set aside a specific amount for your first year of income, for example, emergency reserves would be additional cash on top of those cash holdings.
Staying financially literate and setting money aside for a retirement emergency fund can provide peace of mind and keep your finances healthy. As a result, you're less likely to take on debt or need to sell assets during times of stock market weakness.
Ultimately, your emergency fund acts as a buffer to remove the financial burden from handling sudden issues. If you don't yet have an emergency fund in place, it may be easiest to start building your savings with automatic monthly contributions. Decide on an amount you can afford, and keep your emergency savings in a safe place so you can depend on the money being there when you need it.