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THERE’S NOTHING LIKE a pile of cash to ease our financial worries. Indeed, while today’s spending often brings only fleeting pleasure, not spending that money—and instead building up a cash cushion—will likely deliver ample long-term happiness.
Consider stashing that cash in a low-cost money-market mutual fund or a high-yield online savings account. These accounts should pay more than a savings account at a brick-and-mortar bank, plus separating our cash cushion from our everyday bank account will likely make us think twice before dipping in.
We can think of this cash as our emergency fund—the place we go for extra money if the car breaks down or we get hit with surprise medical expenses. The biggest financial emergency, however, is losing our job. How likely is that? How long would it take to find another job—and how much would we need to cover costs in the meantime?
One rule of thumb: Keep enough emergency money to cover three to six months of living expenses. To figure out how much that is, get your latest pay stub and see how much you take home each month, after taxes and any retirement plan contributions are deducted. From that sum, subtract any additional monthly savings. That should give you a reasonable estimate of your typical monthly spending.
Look to save the full six months of living expenses if your job is tenuous or you’re self-employed. Go for three months if your position is more secure, your spouse also works, you have a home-equity line of credit, you have other savings in a regular taxable account or you’ve funded a Roth IRA. You can withdraw your regular annual contributions to a Roth at any time, with no taxes or penalties owed—provided you don’t touch the account’s investment gains.
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Approaching retirement, many will want much more than six months of living expenses in cash to sleep well. This may not be needed if guaranteed income like Social Security and a pension or fixed annuity covers all living expenses and most discretionary ones.
Contributions can be withdrawn from a Roth without limitations. Any earnings withdrawn before age 59.5 years will bring a penalty. The same is true for funds which entered the Roth via a traditional IRA conversion and were withdrawn before five years from the date of the conversion.
Careful about counting on a Roth IRA as a source of emergency cash. In the past I thought I understood the rules to be as described above. But, to my recollection, the custodian was going to withhold 10% of my withdrawal regardless because at the time I was younger than 59.5 years of age.