That Elusive Emergency Fund: Why You Need It

Give short-term, liquid savings a priority that’s second only to debt reduction.

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Even if you're an active participant in your company 401(k) plan, your savings may still come up short. Do you have enough stashed away to pay cash for an unexpected expense like a home repair? Can you keep up with your bills if you suddenly find yourself without a job for a few months?

Most people should have an emergency fund equal to their minimum monthly expenses times at least three months, and preferably six months. If either goal is too lofty currently, keep in mind that every little bit helps. Even stashing away a few hundred to a few thousand dollars for an emergency can help you sleep better at night.

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John Diehl, a certified financial planner and senior vice president at Hartford Mutual Funds, says your personal situation can guide your emergency savings planning. Are you married, with a working spouse? Is your job in a stable or growing field? In the case of a lost job, do you have other income sources: rental income, alimony or child support, investment income, a trust fund, or a part-time job at a family business?

From there, the first step is to get an idea of the monthly basics that will need to be covered if your income source suddenly dries up: utilities, food, rent/house payment, gas, insurance, and debt installments. Don't forget things like prescriptions. Secondarily, add anything you might need for a job search—your smartphone, high-speed Internet service, dry cleaning.

And, even if your job remains secure, you should have a source to tap for unexpected added expenses—home repair outside the scope of insurance, car maintenance, or unexpected travel.

True "emergency" funds should have the ability to be accessed within one business day, such as traditional savings accounts or money market accounts. But the bulk of your short-term savings can still be working for you—drawing at least modest interest. These funds can be drawn down for use typically inside of a month, sometimes sooner.

[See How to Save More With Savvy Budgeting.]

Investors might consider short-duration, even up to intermediate-duration, bond mutual funds, says Diehl. Of course, these funds are vulnerable to falling values and the principal is not protected. But they can bring at least modest upside growth potential relative to current ultra-low (barely above zero in some cases) money market and short-term CD rates.

Investors might ask themselves whether they're in a position to withstand a 2 to 3 percent hit in a fund at any given time before considering bond mutual funds as a "savings" vehicle, says Diehl. The upside to this scenario: potential positive fund returns and access to that money if needed. In addition, certain mutual funds have gotten more flexible with payouts, offering electronic transfer to checking accounts, for instance.

Investors might, in fact, be too aggressive with 401(k) or IRA savings. It's admirable to max out your allowable long-term investing contributions each month, but perhaps a slice of the pie (say even $25 to $50 of your $200 monthly 401(k) contribution) should instead feed your emergency stash. Think of it this way: You can't get to the job that provides the 401(k) if you can't afford to keep your car running.

Before any savings plan can work, you need to be on top of your debt. Make paying down high-interest credit cards a top priority. Not only will eliminating monthly credit card bills cut down that list of monthly bills that must be paid (whether you're working or not), but having a large cushion on a credit card can be an extra source (although not your first choice) to finance an emergency.

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Ideally, a long-term investing goal shouldn't come at the expense of emergency planning, and vice versa. It doesn't make much sense to have a year's worth of savings sitting in an account that makes nothing.

Diehl makes another point. The wild market swings of the past few years have spooked some investors from risk-taking. And without some risk taking, investment returns are likely to lag over a longer-term horizon. It's particularly important for younger investors—who generally have time to ride out market gyrations—to maintain a healthy view of the risk-reward relationship.