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How Much Emergency Savings Do You Really Need?

By Mark Biller
Sound Mind Investing In our Sound Mind Investing newsletter, we regularly use these columns to emphasize the importance of getting debt free and establishing emergency savings before putting your money at risk in the markets. The solid foundation these steps provide gives you the ability to weather both literal and figurative "storms" when they blow your way, without being forced to sell long-term investments when they're down.

But just how much is enough for an adequate emergency savings reserve? Most financial planners recommend having between three and six months living expenses in an emergency fund. SMI has long suggested a generic $10,000 as a goal. But clearly, $10,000 means different things to different people. With that in mind, let's look at some government statistics to determine how close that $10,000 is to reality.

The U.S Census Bureau reports that the average* married family had income of $63,813 in 2004. However, the figure we're interested in is the after-tax income;after all, the savings reserve is designed to cover living expenses in the event of a loss of income. You don't have to worry about paying taxes if there's no income coming in. So after pulling out an estimated 16% for payroll, federal, and state taxes, the average married family was left with $53,600. That translates to $4,467 per month of spendable income. In a true emergency, some spending can be postponed (entertainment, vacations, 401k contributions, etc.). As a result, I've estimated that only 75% of spendable income would need to be replaced. Therefore, a three-month savings reserve for this typical family would amount to roughly $10,050 ($4,467 x 75% x 3), while a six-month reserve would total $20,100.

Savings Table

The table shows the low and high ranges for three- and six-month savings reserves at various income levels. The $10,000 "rule of thumb" is still a good initial target for a three-month cushion, but many families should clearly consider saving significantly more to be prepared for any longer-term interruption in income. Hurricane Katrina provided a powerful reminder that emergencies can quickly arise when we least expect them. And as the table shows, it takes more than a token effort to be truly prepared.

Note that if your gross income is significantly higher than the $63,813 average, the table somewhat exaggerates your savings needs (because higher tax rates would create lower spendable income to be replaced). Similarly, those with lower incomes should adjust their savings target higher.

It's wise to keep a couple month's worth of living expenses in a money market fund for liquidity purposes, but beyond that it's okay to branch out into conservative bond investments (such as an ultra short-term bond fund). As your savings grow, it's an acceptable risk to take part of the money and go in search of higher yields. Just recognize that in the unlikely event that you need to tap the entire account at once, you may have to sell your bond funds while their prices are temporarily depressed.

Ultimately, the size of your emergency fund will depend to some degree on your personal lifestyle and preferences. Just don't make the mistake of thinking the need for a well-funded reserve doesn't apply to you.

[*Actually the "average" would be somewhat higher, being skewed by the highest earning families. The numbers here are actually the "median" figures, or the point at which exactly half of all married couples are above this amount and half below.]

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