This is the fourth in a four-part series on steps Americans can take in the new year to get their finances in shape.
In the event of a job loss or some other major financial disruption, could you rely on your emergency savings to help you make ends meet until you get back on your feet?
Many can't. About 56 percent of Americans don’t have enough saved in "rainy day" funds to cover three months' worth of living expenses, according to a study by the Financial Industry Regulatory Authority’s Investor Education Foundation.
If you've been procrastinating on establishing an emergency savings fund, the new year is a good time to do it. Here's how to start:
First, determine your monthly expenses. You can calculate those by hand with this spending plan worksheet from the Financial Industry Regulatory Authority's Investor Education Foundation. Another option is to use online tools that automatically track your spending.
Next, decide how many months you'd want your emergency savings to last. According to conventional wisdom, most people should be saving enough to cover at least three months' worth of expenses. Dr. Patrick Payne, the assistant director of the Center for Financial Responsibility at Texas Tech University, said those that fear job loss may decide to set aside funds for a longer period, depending on their line of work.
"Look at your industry and how hard you find it is to get new employment. Use that as a guide," Payne said.
After you're done number-crunching and planning, it's time to pick a savings vehicle. Payne recommends either a traditional savings account or a bank money market account.
When investors do open money market accounts, they should confirm that they are opening a deposit account and not a money market mutual fund account. Money market deposit accounts, like checking and savings accounts, are ensured by the Federal Deposit Insurance Corporation while money market mutual fund accounts are not. And money market deposit accounts allow for easy check writing, while mutual funds do not, which could prove useful if you need to tap into your emergency funds. (Learn more about money market accounts here.)
Some who establish savings accounts might also want to consider bumping up their interest by investing in multiple Certificates of deposit (CDs) with different maturity dates—a strategy known as building a CD ladder.
Here's how it works: A customer may decide to invest $1,000 each in a one-month CD, a two-month CD, and a three-month CD, which generally boast higher interest rates than savings or money market accounts. Upon each CD's maturity, he or she can decide to reinvest the money in another CD. But at a time of unexpected financial hardship or unemployment, savers might need to pocket their CD income instead.
"If you have a major disruption, lose your job and can't find a new one, then the CD ladder can actually replace your income for a more extended period," Payne said.
CD ladders should only make up part — not all — of your emergency savings strategy. Since money from a CD isn't accessible until the CD matures, a consumer should still plan to have a few months of living expenses covered by a savings account. (Learn more about CDs on FINRA's Certificates of Deposits page.)
When it comes to emergency savings, there's one particular temptation that individuals should be careful to avoid: don’t invest your emergency savings in the stock market or other investments that are subject to market risk.
There is no guarantee that a stock’s price will go up, and it might go down, which could leave you with less emergency cash than you would have had otherwise. Even if your holdings did appreciate, you’d be subject to capital gains tax, and possibly at the highest rate if you didn’t hold the position long enough to qualify for the long-term capital gains tax rate.
"People sometimes act out of desperation or get greedy" in chasing high rates of return, which may undermine their efforts to save for a rainy day, Payne said.
"You want the emergency fund to be there when you need it most," he said. A plain vanilla savings account that you contribute to on a regular basis is often the best place to be.