The first time my parent’s threw me a surprise party, I almost called their bluff because of a pack of Bubble Tape.
It was 1998 and the eve of my ninth birthday. In an effort to get me out of the house so the guests could arrive, my Dad insisted I accompany him on a trip to MediaPlay (remember when you went to a store to buy CDs?!). In the checkout line, I stood entranced by all the candy. I picked up a roll of grape Bubble Tape and asked my Dad if I could have it.
“Sure,” he said.
I knew something wasn’t amiss.
You see, in my family my sister and I didn’t just get to pick up candy or toys and have them paid for in full — we had to stake 50%.
As I started to chew on a piece of my “free” Bubble Tape the wheels in my eight-year-old mind started churning. What could possibly be the root cause of this benevolent act? Was my dog dying? Did I perform some task worth a reward that I hadn’t been told about? Was I getting another sibling?
My Dad and I strolled back into my house and I saw my Mom perched on our stairs holding a video camera. She hit record and said, “Hey Erin, why don’t you do a dance?”
As a natural-born performer, I obliged and didn’t find this nearly as baffling as the Bubble-Tape-Gate. Well, not until 30-or-so eight and nine year olds jumped out from various locations and screamed “surprise.”
Fast-forward to 2008 and the years of paying for 50% of what I wanted started getting applied to my habit of saving.
As an RA (my first well-paying job) I had the choice of putting my salary towards my tuition or in the bank. Fortunately, scholarships covered 50% of my college tuition — shockingly the amount my parents required I be responsible for — so my paychecks went in the bank.
I made $6,000 a year which was split into three paychecks of $1000 each per semester. My financial obligations outside of tuition were minimal: cell phone bill and all car-related expenses. So I made the decision to focus on building a nest egg because I could afford to put 50% of each paycheck into savings. I planned the nest egg would fund my dream of moving to New York City after college graduation.
While I called my savings a “nest egg” it ultimately turned into my emergency fund and helped keep my finances afloat my first few months in the Big Apple.
A lot of advice surrounds emergency funds. Financial advisors tend to suggest three to six months of living expenses. They cite this number in case you lose your job and need a cushion while finding another income.
My generic advice to my unmarried, childless peers is $3,000 to 5,000 (depending on your income and debt situation). I say if you have debt and no dependents (including pets), shoot for a minimum of $1,000. Have kids or pets + debt, then save $1,500 in cash.
How did I come up with this number? There is not fancy formula except that it should be able to cover expenses for a couple of months if you suddenly lose your job or if an unexpected cost arises: sick family members, car accidents, broken bones, surgery, your dog eating a pound of chocolate etc, etc, etc .
Once you’re married, or a homeowner or have children and are closer to debt free than not, then think about calculating everything that could go wrong and have enough money to handle all of them happening at the same time. In other words, the deductibles for your insurance policies saved + a buffer for incidentals.
But what if you have debt?
HAVE AN EMERGENCY FUND ANYWAY!
Sorry — did that come off a little aggressive? I don’t care.
I understand the compulsion to pay off debt as quickly as possible. You think you’ll be in a better place if you can crawl out of the red and so you focus every last penny on your efforts. But what happens if an emergency arises and you don’t have a buffer of accessible cash to cover the cost? You might take out a loan, put the cost on credit cards or horror of horrors – raid your 401(k). Essentially, you’re digging yourself deeper into debt because you elected not to have a few grand saved up.
An emergency fund also keeps you from dipping into that 401(k) (or IRA) account you so diligently set up when you started working. Your retirement fund should be viewed as a last resort option. Not just because it hurts your savings for the future — and you have to repay that loan — but it can come with heavy fines.
There is often a limit you can take from your 401(k) as a loan — typically no more than 50%. You can repay the loan with the same deductions from your paycheck you’ve been using to contribute. Some companies even require you to payoff the loan before you start contributing again. And if you leave your job (or get fired), you’re required to immediately repay the loan. If you’re younger than 59 (and-a-half for some reason) you’ll likely also get slapped with 10% penalty tax.
There are also hardship and 72(t) withdrawals. The first you have to qualify for and you may still have to pay the 10% early withdrawal penalty. The latter allows you to take out a fixed amount based on your life expectancy, but doesn’t include the 10% tax. However, the fixed amount could be a meager sum depending on what age you start the withdrawals and will likely annihilate your retirement savings.
In short — a 401(k) should never be viewed as an emergency fund. It is absolutely the last resort if your other options (and funds) have been depleted.
Building an emergency fund can be a painfully slow process. I wish I could still afford to contribute 50% of my paycheck to savings — but these days I can only defer about 15% into savings (not including my 401(k) and pre-tax transit contributions). Don’t get discouraged if you can only afford putting aside as little as $20 out of each paycheck into your emergency fund. Eventually, you’ll start making more money and will be able to contribute more to savings. In the meantime, at least you’re creating a little buffer for yourself. Or you could just start a side gig and put all your extra cash into building up your emergency fund.
[Piggy Bank image taken from Flickr]