Emergency funds save big money on interest, penalties and taxes by preventing dipping into investments early or using credit to pay unexpected costs.
An emergency fund isn’t just a good idea. It’s necessary. An emergency fund is generally described as three to six months of expenses. Most articles that give reasons to set up an emergency fund list things like job loss, unexpected medical expenses or home repair. While we’ll cover those and other reasons below, we’ll also dig deeper, explaining why an emergency fund is the cheapest way to handle those costs – much cheaper than dipping into investments or using credit.
People without emergency funds end up paying thousands more in interest charges from paying for emergencies with credit. Even people with money saved can end up paying thousands in taxes and penalties for dipping into their investments if they don’t have an emergency fund in place.
Below are our top five reasons to set up and maintain an emergency fund.
1. Emergency Funds Can Soften a Job Loss
Most financial advisers recommend an emergency fund contain three to six months of expenses. The idea is that someone who loses their job can still cover their budget while they look for new employment. However, the U.S. Bureau of Labor Statistics puts the average duration of unemployment at 30 weeks, which is 7.5 months, so anyone building an emergency fund should consider building a larger emergency fund.
Using invested money or credit cards to stay afloat during a job loss can cost thousands in taxes, penalties and credit card interest charges. Keep reading to find out why.
Related: 5 Ways to Save Now Even if You Don’t Make Much Money
2. Emergency Funds Can Soften Medical Emergencies
An emergency fund can soften the financial blow from a medical emergency.
Very few people will get by without at least one medical emergency in their lives. Even a procedure as routine as an appendectomy has a national average price of $28,000. An unexpected childbirth can set a couple back anywhere from $4,300 to $70,000. Cancer, infections, urgent medical treatment for children, a car crash or other sudden medical event can put a serious dent in a person’s finances.
While the purpose of health insurance is to level out the economic bumps from health surprises, it doesn’t cover everything. The average individual deductible for employer sponsored healthcare plans rose 47% in the five years after 2009, reaching $1,217 in 2014. Out of pocket costs can reach $6,000 a year or more. If a health insurance claim for a procedure like an appendectomy gets denied, unexpected medical costs can run into the tens of thousands of dollars.
Related: How to Tell if Your Doctor Takes Money from Big Pharma
3. Emergency Funds Can Avoid Costly Credit Card Interest
An emergency fund can save literally millions in interest.
Someone who has an emergency fund can pay off unexpected events like a sudden medical or other expense. A patient whose insurance company denies a claim for an emergency procedure like kidney stone removal might wind up with a bill for $20,000. Without an emergency fund, the consumer may end up maxing out their credit cards to pay it. $20,000 in credit card debt, carried on a card with a typical interest rate of 22.9% would rack up $4,580 in interest charges the first year alone. Letting that debt sit for 30 years would create a whopping pile of nearly ten million dollars in credit card debt. Even someone who manages to pay down their $20,000 credit card debt before it grows will take nearly 19 years to pay it off, making payments of $800 per month. The interest charges alone will cost them over $18,000.
The person with the emergency fund in place, meanwhile, simply pays the debt. They not only avoid thousands in interest, but they can put their $800 a month into savings and investments, earning interest. In the time it took the patient without an emergency fund to pay off their debt, the person with the emergency fund could invest the monthly payment at 8% and earn $429,000.
Related: How to Raise Your Credit Score
4. Emergency Funds Can Stave off IRA and 401k Penalties and Taxes
An emergency fund can stop emergencies from costing an investor thousands in investment penalties and taxes.
Traditional IRAs and 401ks carry a 10% penalty for withdrawals before the investor reaches age 59 1/2. Someone who has to take $10,000 from their IRA for unexpected home repairs will fork over an additional $1,000 in penalties. Having an emergency fund could save that extra cost.
Other costs associated with selling off investments early to cover emergencies include higher tax bills and brokerage fees. Someone with a taxable income of $50,000 who sells off $10,000 in investments to pay for an emergency will most probably exceed the $52,800 threshold for the Alternative Minimum Tax (AMT). Since the AMT eliminates a spate of common deductions and tax credits, the taxpayer could find himself paying thousands more in taxes on top of the already painful cost of the emergency. Even those who aren’t pushed over the AMT threshold could still find themselves bumped into higher tax brackets by emergency selloffs of investments, resulting in higher tax bills.
Related: Why I Pulled Money Out of My Roth IRA
5. Emergency Funds Can Help With Other Emergencies
Aside from emergency medical care, emergency funds can cover job loss, emergency pet care, home repair, big tax bills, funeral costs, surprise travel, hours cut at work, car breakdowns and other rainy day events.
Emergency Funds for Hours Cut at Work
Even someone who doesn’t lose their job can have their hours unexpectedly cut. An emergency fund can prop up a family’s budget during a temporary cutback in hours. It can also provide a comforting safety net while a breadwinner looks for part time employment or other ways to supplement sagging income levels.
Emergency Funds for Home Repair
An emergency fund can lessen the pain of surprise home repairs. A new furnace can cost anywhere from $4,500 to $21,000 installed. A typical new roof costs about $9,000 for a 1,500 square foot home. Even smaller emergency repairs like a blown hot water heater or a burst pipe can run into the thousands. Someone who has an emergency fund in place can avoid interest charges by paying for repairs outright.
Emergency Funds for Car Repair
Emergency funds can cut the costs of sudden car repairs. A blown head gasket, slipped clutch or even an exhaust system in need of replacement can easily create a surprised repair bill running into the thousands of dollars. Having an emergency fund on hand can save investment penalties and credit card interest from car repair emergencies too.
Emergency Funds for Big Tax Bills
Emergency funds can help with large tax bills that come out of the blue. Someone who pays on average $5,000 a year in taxes can suddenly see a big jump in any one year. Big boosts can come from windfalls like inheritances, pay raises or investment selloffs, to name a few. Another way to see a big jump in taxes from one year to the next is by being forced to pay the Alternative Minimum Tax. An emergency fund can smooth out the financial pothole caused by irregular tax sticker shock.
Emergency Funds for Funeral Costs
Emergency funds can be there in a pinch when you least want to think about money. Nobody wants to think about a death, but unfortunately they’re as common as births. When a loved one dies, having a financial cushion in place can make it easier to cope with missed time from work, travel costs and funeral costs.
According to the National Funeral director’s association, the average funeral costs $8,300. Being able to pay for that cost outright instead of dipping into investments or putting it on a credit card can save the bereaved a lot of stress and money.
Emergency Funds for Pet Care
Emergency funds can help with emergency pet care. Nobody knows just how much they’re going to love a pet until they’ve looked into its big trusting eyes. People who think they wouldn’t spend much on medical care for a pet can surprise themselves when the chips are down.
According to PetInsurance.com, a beloved dog’s liver cancer can cost its owner $8,500. The typical annual interest on that amount saved by having an emergency fund is $1,946.
The Best Way to Set up an Emergency Fund
The best place to put emergency fund money is into an online savings account. Online savings accounts generally earn more interest than regular savings accounts in brick and mortar banks. Money in savings accounts is liquid and can be accessed on short notice without penalty. See our rundown of the best online bank savings accounts with high yield interest here.
Study: Appendix surgery costs differ around U.S. – CBS News
Yes, you are paying a lot more for your employer health plan than you used to – Washington Post
Kidney Stone Treatment – CostHelperHealth.com
U.S. Bureau of Labor Statistics
Funeral Service Facts – National Funeral Director’s Association
Top 10 Pet Surgeries – PetInsurance.com