saving » The Art of Money

How to Calculate the Size of your Emergency Fund

Nov 122011

Some people like to proscribe the specific amounts of money people should have in their emergency fund. You should have $1,000, 3-6 months expenses, I’ve even heard that you need 2 years of living expenses socked away!

What these overly dictatorial suggestions miss is that the size of your emergency fund will depend on the uniqueness of your situation.

Let’s take two people, Jack and Jill, to illustrate what I mean.

Jack
Jack is a 24-year old recent college graduate working as a video game designer for a top firm in LA. Jack lives on Hot Pockets and Ramen noodles, and treats himself to the occasional Lean Cuisine. Jack’s hobbies are playing video games and tooling around on his Mac, downloading free songs. Jack has low monthly expenses; he only needs a minimum of $2,000 per month to survive. The video game industry is growing rapidly, and he and his friends all got jobs right out of college. A couple of his peers even waited for a month to weigh job offers against each other. Further, in the past 2 years that he’s worked at his firm, no one has gotten fired; in fact the company has been hiring like crazy to keep up with demand. Most of the senior executives have been there for 5, 10 and 15 years.

Jill
Jill is a 42-year old investment banker and mother of 3 children. She works for a mid-size bank in NYC. Jill and her husband have grown accustomed to the fine dining available in the Big Apple. They have a mortgage on a new house, two car payments and are financing their oldest son’s college education. Jill needs a minimum of $6,000 per month to survive. There has been turmoil in the financial services industry, and people are getting fired left and right. Several of her coworkers who have been let go have been searching for jobs for more than 6 months; some have left the finance industry completely because no one is hiring. Many of the senior executives have been let go.

What would be the ideal size of the emergency funds of Jack and Jill? Obviously, they would be vastly different.

For Jack, the likeliness of getting fired is relatively low. The video game industry is growing, and talented designers are not on the job market for long. Even if he did get fired, due to his low-cost interests, it wouldn’t be a terribly expensive event. Jack might want an emergency fund that’s sufficient to cover 2.5 months of job searching.

Jack’s Emergency Fund: $5,000

For Jill, the likeliness of getting fired is relatively high. The financial industry is laying people off, and it takes a long time to get a new job. The cost of getting laid off is higher for Jill, because she owns a home and has a family to support. Jill might want an emergency fund that covers 7 months of job searching.

Jill’s Emergency Fund: $42,000

How big should your emergency fund be? What factors should you consider when determining its size? Please share in the comments!

Roth IRA or 401(k): Which is Better?

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Nov 052011

For gainfully employed young professionals in their 20’s, the two most attractive retirement investment vehicles available are the 401(k) and the Roth IRA.

Which one should you choose? Should you invest 100% in one or the other, or split the two? I’ll answer those questions in this blog post.

I hope you’re already taking advantage of the magic of compound interest, but if not, I’ll offer a quick example to illustrate the importance of saving EARLY.

John is a 25 year old that invests $100/month into a retirement account and lets it compound at 8% for 40 years. He will end with $380,000 to retire on.
Jane is a 45 year old that invests $100/month into a retirement account and lets it compound at 8% for 20 years. She will end with $65,000 to retire on.

In other words, just 20 years of not investing cost Jane $315,000! Use this free compound interest calculator to run your own numbers.

OK, so we know we should save for retirement, but the question remains: 401(k) or Roth IRA?

401(k) BENEFITS
The 401(k) offers one primary advantage: the company match. Many companies offer an employer match up to a certain percentage of your income. For example, if your employer will match dollar-for-dollar your 401(k) contributions up to 6% of your monthly income, and the maximum you can contribute is $100, your employer will ALSO invest $100 into your 401(k), for a total of $200/month.

As an example, let’s take John and Jane again, where John has a 401(k) with employer match and Jane does not.

John invests $100/month with a dollar-for-dollar employer match for a total of $200/month and lets it compound in a retirement account at 8% for 40 years. He will end with $710,000.
Jane invests $100/month without an employer match and lets it compound in a retirement account at 8% for 40 years. She will end with $355,000.

By taking advantage of the employer match, John doubled his money and earned an additional $355,000!

ROTH IRA BENEFITS
The primary advantage for the Roth IRA is that you can withdraw the proceeds tax-free. If you anticipate earning more money and being in a higher tax bracket as you get older, then contributing to a Roth IRA will mean more money in your pocket. Using a Roth IRA vs 401(k) calculator from Bankrate.com, I calculated the difference for my financial situation:

At my current salary, I’m paying 15% of my wages in federal income tax. Assuming a 28% tax rate when I retire, contributing to a Roth IRA will net me $36,749 more than if I had contributed the same amount to a 401(k). Remember though, that this DOES NOT calculate the value of the employer match mentioned above.

A secondary benefit of the Roth IRA is that you can withdraw the principal at any time, tax and penalty free. This means your Roth IRA doubles as an emergency fund, but earns WAY better interest over the long-term than any high-yield savings accounts or money market funds out there. I actually used my Vanguard Roth IRA as an emergency fund in 2010 when I withdrew $1,000 of principal to pay down my credit card debt. Not something I’m proud of, but it sure helped me out in a bind.

FINAL RECOMMENDATION
1) Contribute up to your employer match in your 401(k), and then

2) Max out your Roth IRA*

*the current limit is $5,000 per year, assuming you file as an individual earning less than $107,000 per year.

Do you have a 401(k) and/or Roth IRA? How have you allocated your money between the two retirement accounts? Are you saving for retirement in another way? Please share in the comments!

The 3 Things You Need to Know About Emergency Funds

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Nov 032011

I’m going to go ahead and make a bold statement here: everyone should have an emergency fund.

What do I mean by an emergency fund? I define an emergency fund as a zero interest, liquid asset that will get you through expensive, one-time events that are likely to occur. Usually, this means cold, hard cash.

The fact of the matter is that we live in an uncertain world, and we never know what may befall us in the future. We may lose our job and need to cover our expenses without a salary. We may need an emergency medical procedure that isn’t fully covered by insurance. A close family member may need a loan. Our best friend may need to be bailed out of jail. Depending on your situation, there are innumerable things that can happen, and it behooves us to have an emergency fund that we can draw on to avoid financial disaster.

There are several attributes that I use to describe an emergency fund, so let me break them down one-by-one.

Zero interest. This means your emergency fund SHOULD NOT be a credit card. Having a credit card that charges 14.99% interest if you don’t pay off the balance is a very expensive emergency fund, and will likely worsen your financial predicament. Zero interest means cash that you can draw on where you don’t have to pay any interest on the money. Even better, your emergency fund will be earning interest, as I do with my ING Direct Orange Savings Account.

Liquid. You must be able to draw upon your emergency fund as you need it. If you lose your job and need to buy groceries, trying to sell your rare coin collection will probably mean you go hungry. Again, this usually means cash, but could also include financial instruments like a CD ladder.

One-Time, Expensive, and Likely. I know, these are three attributes packed into one, but they’re all related in that they will determine the size of your emergency fund. For example, if we’re building an emergency fund to tide us over until we find a new job, we will need to know roughly 3 things:

our bare-bone monthly expenses
the median amount of time it takes professionals in your industry and geographic area to find a new job
how likely it is that lay-offs will occur at your company.

In a future blog post, I’ll use two hypothetical situations to show you how to calculate the size of your emergency fund. For now, I just want to introduce you to the 3 things you need to consider when building one.

Do you have an emergency fund? If so, is it zero interest, liquid and enough to cover one-time, expensive and likely events? Please share in the comments below!