At some point in your financial life you have more money than you need to live on, so you invest it. But even after you have built a big nest for the money eggs, you still need a cushion, an emergency fund, or some readily available cash that’s always there when you need it. But how much do you need? Here are four ways to help you find the answer.
First things first
The first step in creating a cash cushion is to realize you really need one. Stuff happens. Things change. Big expenses pop up. Families change. Careers take twists and turns. Without a cushion, you may have to liquidate investments you intended to hold for the long term, skewing your risk level or triggering capital gains at the wrong time. But if you plan ahead, no problem. You have a cushion, a convenient and liquid safety net. Now, how much?
The magic number way
The magic number way is derived from a bit of family lore you grew up with or heard from your parents, the practical aunt or the rich uncle. It’s an absolute number, which makes it easy to spot and aim for. “A million dollars in the checking account” is one client’s definition. Another one is “always have ten thousand dollars ready.” Based on my experience $10k is a little low for the cushion, and a million is a little high. The right number is somewhere in between, chosen by you and your partner. The point is, do have the discussion and do set the money aside.
The formula way
The formula way is usually based on the time you might need the cushion to fortify your finances, say, “six months salary” or “a year of living expenses.” Just check your W-2 or 1099 to determine how much income you might need to replace, or calculate how much you actually spent in the last year. Be honest with the numbers. If you spend $15,000 a month, there’s no sense pretending $10,000 will be enough. Let your real numbers guide you. You can solve this.
The practical way
The practical way is a common sense, rational guess at how big your cushion should be. Those who can make non-emotional money decisions or who value a rational financial approach like the practical way. It’s your best guess, and you know better than anyone what the number has to be. Cross-check your best guess with the magic number and formula ways to confirm your judgment. Set the number and set it aside.
When you fall back on the cushion, what next?
Sometimes you need the cushion. You may be taking your career in a new direction. Or having a child. Or taking the trip of a lifetime. Or supplementing a loved one for a while. Don’t feel guilty for tapping into the cushion. That’s why it’s there. But if it’s more than a very temporary situation, be sure to check in with you advisor for a discussion about your financial situation and goals. Often, there is a change that should be made to your investments because of changes in your family, career, health or vision for the future. When the temporary need ends, make a plan to refill your cushion account.
Do it today
Putting a cushion in place is one of the easiest ways to prepare for an unknowable future. Using any one, or several, of the cushion calculators you can figure out how big your emergency fund should be. Then you can rest easy, feel smart and focus on what’s really important.
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