education | savings strategies
Why It Pays to Plan Ahead for Unexpected Expenses
By Kent Thune, CFP®
While you've likely set funds aside for upcoming large purchases and vacations, it's also important to plan ahead for unexpected expenses you could potentially encounter.
As emergencies can arise at any time, it's wise to build up your liquid savings for quick and penalty-free access. It's also smart to balance the need to earn competitive rates of interest with the need to minimize risk — all while keeping your money growing.
First, you'll want to determine how much money to set aside, and then choose which types of accounts or savings vehicles to use. Here's insight into why preparing for the unexpected can be so beneficial, and guidance around making your money work as hard as possible.
The primary reason to financially prepare for unexpected expenses is that you likely don't want to fund these expenses with debt. For example, if you get into a car accident, it's not ideal to use your high-interest credit card or dip into your retirement savings to pay the deductible on your auto insurance. These actions may actually end up costing you more money long-term.
It's also wise to be prepared for larger emergencies, such as a job loss, as millions of Americans have unfortunately experienced during the coronavirus pandemic. According to a 2019 survey, nearly two-thirds of Americans did not have savings set aside for such extreme emergencies, however since the start of the pandemic, American’s overall savings rate increased to 33% in April 2020.
Giving some thought — and taking action — can put you in a better position to cover unexpected outlays.
Use the "Bucket System" for Emergency Funds
Financial planning for the unexpected begins with building an emergency fund. A general rule with emergency funds is to have up to three to six months of living expenses in a liquid, interest-bearing account. But this is a large amount of money to keep in just one low-interest account. To make your money work harder and smarter, you can break your emergency fund into different buckets.
Every household is different, therefore, it's up to you to think of which emergencies are most likely to occur and estimate their costs. For example, repairs for home appliances or automobiles may be more likely to occur than a visit to the emergency room or losing your job.
Once you have your buckets, you can fund them with the appropriate types of accounts.
Types of Accounts to Use for Emergency Funds
Planning for unexpected expenses is all about risk management. As mentioned, there are multiple types of unexpected expenses, each with varying degrees of risk they will occur. But you'll also want to manage inflation risk, which may require using a variety of savings vehicles that can help you stay ahead of inflation.
To manage these risks — while making your money work as hard as possible — it may be necessary to have multiple accounts. Based on your personal situation, there are a variety of FDIC-insured bank products and other creative options you may want to consider:
1. High-yield savings account: Savings accounts offered at traditional banks earn as little as 0.05% interest on average. But online banks offer higher rates with a high-yield online savings account. This account type is liquid, which makes it ideal for covering the emergencies that are most likely to occur, such as household repairs.
2. Certificate of deposit (CD): With a CD, you can often earn more interest than with a high-yield savings account. Try to avoid CDs that require a penalty for early withdrawal. As a smarter alternative, check to see if your bank offers liquid CDs that have no withdrawal penalty — this can allow you to access your money faster and easier.
3. Health savings account (HSA): If you have access to an HSA through your employer, you can use this account to put aside money for health-related expenses. Contributions are made on a pretax basis. Maximum contribution amounts for 2020 are $3,550 for individuals and $7,100 for families. Additionally, individuals age 55 or older can make an additional annual "catch-up" contribution up to $1,000. Since HSA contributions are not required to be used during the year of contribution, you can carry them over into subsequent years. You may also have the option to invest your HSA in mutual funds. This makes HSAs ideal for the larger unexpected healthcare expenses, such as emergency room visits or surgeries.
4. Roth IRA: When deciding whether to invest in your emergency fund or save for retirement, remember you can accomplish both with a Roth IRA. Keep in mind the IRS imposes a 10% penalty for withdrawals made before age 59 ½ . After this milestone, Roth account holders may withdraw contributions without paying taxes or a penalty. It's also possible to withdraw earnings penalty-free from a Roth IRA for certain qualifying events, such as a first-time home purchase, education expenses or certain medical expenses. Still, it may be best to use a Roth IRA only when your other emergency funds have been fully tapped.
You can protect the financial wealth you've earned by building a smart emergency fund. With the right types of FDIC-insured accounts and savings vehicles, you can put aside enough to cover the worst-case scenario — but also find a way to grow money while it remains accessible.