Tuesday, March 10, 2009

Where to keep an Emergency Fund

Yesterday I told you how Suzy Orman updated her 2009 Action Plan (you did get the free download, right?) to focus more on building and emergency fund and less is paying down debt. This goes against everything you've heard before, but in these uncertain times makes very good sense. But just what is an emergency fund? That is, what accounts should be included.

First the funds must be reliable, so that means they should be safe and insured. If you should lose income source you don't want to rely on something like stock investments that fluctuate dramatically from one day to the next. Actually, to be totally clear let's say NO STOCKS. Yep, I'm screaming, don't include stocks among your emergency assets.

The next qualification for an emergency fund is that it be readily accessible (a.k.a. liquid funds). It must be available when you need it.

So what accounts can be included in your emergency fund?

Savings Accounts: This is a no brainer. Savings accounts are simple, insured and easily accessible. It's a good idea to keep a secondary savings account for emergency savings. DO NOT set it up as your checking overdraft safety net. DO establish automatic deposits to keep it building.

Money Market Account: Again these are insured, but they also earn a higher interest rate than regular savings. However, they often have a minimum opening deposit. These accounts are nice because you can add deposits, withdraw immediately and they are safe.

Certificates of Deposit: Also insured and higher-earning, but they do lock up your money for a specified time period. However, early withdraw penalties are typically low.

What about your retirement funds? This one always carries a big debate. Yes, most people have a substantial amount of money in 401(k)s or IRAs, but these should only be used in extreme situations. Don't go about your days thinking your covered by these accounts. The penalties for withdraw or loans against your retirement accounts are hefty. If you withdraw money from your 401(k), you are going to pay taxes on the amount your withdraw plus penalties. It may also throw you into a higher tax bracket and cost you more in taxes on the rest of your income. Withdrawing $10,000 from your retirement will cost approximately $3,000 in taxes plus another $1,000 in penalties. Taking a loan against your 401(k) is also dangerous, you'll have to pay it back and you can't take a loan if you aren't working.

To withdraw funds from your IRA you must be:
  • Contributing for 5 years
  • Age 59 ½
  • Disabled
  • Qualified “first-home” purchase (a withdrawal of up to $10,000)
Withdrawals for any other reason are considered nonqualified distributions and may be subject to income tax.

How about credit cards or home equity loans? Using debt accounts for emergency shouldn't be part of your plan. However, if the emergency arises and you don't have cash funds to use, then you'll need to turn to credit. Racking up debt while working through a loss of income is not only costly, but adds stress. That said, it is a good idea to pursue a home equity line of credit if you don't currently have one. Unlike a home equity loan, a line of credit only needs to paid back if you use it. But, falling home values are making home equity lines of credit harder to come by, and so, it's a good idea to apply before you actually need it. Keep a home equity line of credit and a low-interest credit card in your back pocket for when things get really rocky.

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