An area of financial planning that is sometimes neglected is the managing of cash. Most people in general realize that it is important to keep some money in reserve for unexpected expenses. Unfortunately, many individuals have too little in reserve to meet emergencies, while others keep too much and lose out on investment opportunities.
When considering cash reserves they can be broken down into three specific categories. The first being the standard one, a reserve to be used for emergencies. The next would be a fund to meet large planned expenses. The final one is cash, as part of an investment portfolio.
The amount one needs to establish for an emergency fund can be considered either in terms of a specific dollar amount, or living expenses for a period of time. One rough guideline would be to have reserves on hand to meet at least three months of living expenses. The emergency fund is intended to meet, either a loss of income, or unexpected expenses.
The loss of income is typically from one’s job. Generally if someone gets sick or injured, there is disability, worker comp, if injured on the job, or unemployment. These benefits will only pay a portion of one’s original salary, so people will need something in reserve to make up the difference.
In addition people need to be conscious of a loss of income even when maintaining one’s job. People in sales, or who have their own business typically have pay that is variable, so a loss of income frequently occurs in a recession. Also, people who earn overtime and bonus pay, should realize those extras can sometimes be reduced.
Unexpected expenses generally fall into three categories: the house, the car, and medical. Obviously a renter would not need to worry about home repairs, and someone driving a newer car under warranty would not have unexpected car expenses Medical bills are largely a function of one’s deductible, so if you have a high deductible plan make sure you have reserves to cover it.
Someone needs to look at their overall situation to determine their emergency fund. A professor with tenure who rents and drives a newer car probably would not need a large emergency fund. However, a construction worker or contractor who owns a home, drives an old truck, and has a high deductible medical plan would need significant reserves.
The category of reserves for planned expenses would normally cover anticipated major obligations over the next several years. This might include savings for a new car, a down payment on a house, a major vacation, or a wedding. With cash earning virtually nothing, someone might be tempted to put that money in the stock market, but for a time horizon less than a few years that money should be invested conservatively.
For people’s retirement accounts having some money in cash could be part of an investment strategy. However, except for unusual circumstances I would not recommend keeping large amounts in cash reserves. This is especially true for younger people, who oftentimes keep excessively large cash balances in 401K plans. Over time cash tends to be a drag on performance.
For people who are taking distributions from an IRA or 401K plan reserves should be established before the distribution. Money that will be taken out in the next year or two should be invested in a money market or short-term bond fund. The balance of the account should still be invested in accordance with one’s longer-term objectives.
A significant portion of the American population lives paycheck to paycheck. Unfortunately when unexpected expenses arise, people commonly use credit cards, and wind up incurring significant interest expenses. That is why it is important to establish an emergency fund. Just reducing expenses $20 per week will save a $1,040 per year and improve one’s financial health.