How Much Should You Keep In Emergency Reserve?

Job loss, unexpected trip to the hospital, a tree falls on the house – events like these can send the unprepared into a financial tailspin. An emergency reserve is your mini financial self-insurance policy, so we all know we should have one. But, getting around to funding that reserve tends to sit on the to-do list for many. And things only get more complicated when you own a business.

In addition to answering big picture questions like how much you’ll need to retire and how to manage investment allocations, we get many practical questions about cash reserves and rainy-day funds. How much cash should I keep? Should I hold it in the business or in a personal account? And how can I make sure this money is at least earning something for me? While the answers vary case by case, every plan should include proper reserve planning. So, how can you maintain appropriate personal and business reserves?

One Size Does Not Fit All

You’ve likely heard the “three to six months of expenses” rule of thumb. You spend $10,000 per month? Put $30,000 in savings, check the box and move along. This is a simple enough figure to arrive at, and it works for many.

But, don’t just assume one size fits all – we recommend answering three questions. Does your income fluctuate? How close are you to retirement? And, finally, where should you hold your reserves?

Does My Income Fluctuate?

First, look at your income streams and how you get paid. Do you get the same monthly or bi-weekly paycheck like clockwork? Or, are you in a sales position where your income fluctuates significantly from month to month?

Assuming you have consistent income and spend $10,000 per month for your mortgage and other living expenses, a $30,000 three month reserve will likely work for you. On the other hand, if you’re a salesperson with the same $10,000 per month in expenses, but you might make $50,000 one month and $5,000 the next, it’s likely better to keep a full $60,000 in reserve and perhaps another $60,000 in accessible investments to give you the cushion you need in case of an emergency.

Let your preference guide you within these ranges. If a little more cash in the bank helps you sleep better at night, the effort required to build a bigger reserve could be worth the peace of mind.

What About My Business?

You can use the same income fluctuation principal to set reserves for your business. If you’re a service-based business like a dental practice with very steady cash flow, we commonly see a reserve equal to one month of overhead expenses. If, on the other hand, you’re a construction company that makes most of its revenue in a few big projects, it’s reasonable to build reserves of six to twelve months.

How Close Am I To Retirement?

As you approach retirement, the amount you should keep in an emergency reserve increases. People at this stage tend to become more conservative with their overall investments. Further, people that are aging and closer to retirement might face more threats of unplanned layoffs.

At a minimum, you want to have that six-month mark fully funded, and you’ll hold onto it throughout your retirement. But some prefer even more. Several of our retired clients prefer to have a full year’s worth of cash on hand as a buffer which can cover things like unexpected medical expenses or other surprises.

Where Should I Hold My Emergency Reserves?

It takes tremendous discipline to maintain an emergency reserve. It can be tough see $50,000 sitting in a checking account that you could use for a vacation or a new car. And, it’s also irritating to know that cash in your average checking account is earning essentially zero while your other investments are hard at work.

For many, and online high-yield savings accounts can be a great solution. An online savings account with Capital One or Ally Bank will pay higher interest rates than your standard bank savings account. You can generally access your money any time without penalty and keep the interest you’ve earned. And, the money is out of sight and out of mind. You can build your reserve, know it’s there for a rainy day, but not have to stare it in the face every day and resist using it for that extra vacation.

If the idea of having some of these funds work a bit harder for you, consider splitting your reserves between a savings account and a conservative investment account. If you’re the consistent paycheck person with 10 years or more to retirement, you can keep the first three months in savings and invest the rest of the money in a conservative investment portfolio that won’t get dinged by taxes if you needed it for an emergency.

Getting the most out of your money also translates into developing a savings mindset – at any age.

What If I Don’t Know What I Spend Each Month?

Don’t worry, you’re not alone! Here’s an exercise that can help. You’ll track three months of expenses with a money manager tool like Mint. We regularly do this with clients approaching retirement to make sure what they think they are spending is what they’re really spending. Once you have these expenses compiled, group them into fixed, variable and fun expenses. Fixed expenses don’t change month to month, like mortgage payments. Variable expenses are necessary expenses that change a bit each month, like groceries or gas. Fun expenses cover the meals out, vacations and everything else that may not be necessary but makes life fun.

With this data in hand, you can begin to set appropriate reserve levels as we’ve just discussed. In addition to setting recommended emergency reserve levels, this helps us set valuable targets for retirement savings and identify what you’re able to set aside monthly or annually toward your financial goals.