Are you one of the millions of workers who have saved less than $1,000 as emergency money?Almost as bad as saving so little, you might be putting your rainy-day fund in one of the five worst places possible. What are they, you ask?
A 2012 survey by Employee Benefit Research Institute found that 30% of the workers polled have saved or invested under $1,000 aside from their home and defined benefit pension plans. And it found that one-third of those polled had to dip into their savings to cover basic expenses in the last year.
Losing a job or facing a financial crisis can send you into a panic. But take a moment to consider how much you’ll need before deciding what funds to cash in. It’s important to have at least six months’ worth of expenses.
Look at how much time it takes to find a job in your field. If you’re a private business owner, store away even more.
“Have as much as three years of spending money available, perhaps even more,” said Jesse Giordano (no relation to writer), family wealth director for Morgan Stanley Smith Barney in Great Neck, N.Y. He sees many business owners kicking themselves for not shoring up enough to cover their own salaries during times of crisis.
As far as which funds to tap, for starters, heed the warnings of financial advisers. They advise against six key financial instruments, starting with — you guessed it — your retirement.
Your retirement accounts are geared toward giving you returns over a long period of time, and incentives are in place for a reason, Giordano said.
“In retirement vehicles, the tax incentives are really there because the government’s trying to incentivise people to save for the long-term,” he said. “So they’re intentionally trying to penalise individuals who are not making those long-term decisions.”
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Some investments carry stiffer penalties. Obviously, the ones keeping your money on lockdown until you’re 59 ½ are at the top of the list, but even their penalties can vary. Others will charge you recurring fees that may whittle away whatever interest you have earned while investing.
Here are five financial instruments to avoid when stashing your emergency money, or at least, to consider cautiously:
1.Traditional vs. Roth IRAs: If you’re under 59 ½ and you’re in a traditional 401k, you’ll have tax penalties for early withdrawal of 10%, in addition to having to pay income taxes. Roth IRAs are a little less risky since you’ve paid your income taxes at the time you deposited, but there still are penalties, said Giordano. If it’s an IRA from your workplace, ask your benefits department if you’re allowed to borrow against the plan in an emergency, and what the fees and costs are if you do. Also ask if they allow in-service distributions, which allow individuals to take money out of the plan for reasons other than termination, said Giordano.
There are some exceptions, said Marc Specht, financial adviser of Kuttin-Metis Wealth Management in Manhattan. You’re able to borrow $10,000 (without penalty) to buy your first home, or use it to pay for health insurance costs if you’ve been laid off.
2. CDs: These are a common emergency fund investment. Very short term CDs, such as those for 90 days, may be fine, but the repercussions for cashing them in early before they mature can be huge. “In most cases you’re actually going to lose money on putting it in a CD and then pulling it out before (it matures),” said Tony Aguilar, founder of Austin-based Amiti Advising. Because of the penalty fees, “even the interest that you’re earning is still not enough to cover the penalty fee like in the end.”
3. Bond funds and mutual funds: Many don’t realise there are commission fees charged with bond funds, and you can incur a loss through fees and expenses charged for mutual funds. The funds often lure investors with a 4% or 5% interest rate, but the fees add up. Some fees you’ll pay upon the initial purchase of the bond, but others can recur annually, and can be as high as 3% per year. “In addition to inflation, that’s taking another 3% from your money, so you know, if you didn’t make 6% that year, you’re losing money,” said Aguilar. Always ask about the fees.
Another consideration: While the mutual fund may have a fixed interest rate, the share price may change. “So if you needed some money and you bought it at $10 a share and you needed to sell and get out, and you sell it for $8 a share, well, it’s a 20% loss,” said Specht.
4. Annuities: Most annuities have different lockup terms, usually four to seven years, in which they keep your money bound. Similar to a CD, if you want to withdraw your money early, you’ll pay a declining penalty. “So for example, if it’s a seven-year product, if you took money out in year one, there might be a 7% penalty. Year two might be a 6. Year three might be 5,” said Specht. Some, however, allow you to withdraw 15% of your money early. Others allow you to withdraw money early without penalties, but they’re typically more expensive, said Specht.
Also, a lot of the perks with variable annuities — such as guaranteed income and guaranteed withdrawal features that credit your account when the market is up or down – “don’t make as much sense until you get to more into your mid- to late 50s,” said Specht.
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5. Life Insurance: Don’t borrow from your life insurance policy if you won’t be able to make the premium payments. You want to cover the premiums to keep the policy going, and you don’t want the policy to lapse.
The Investing Answer: Shore up your emergency funds these two ways:
Lines of credit available for emergencies. “Many banks are eager, especially with interest rates as low as they are today, (and lines of credit) could be an attractive source of liquidity in the event of an emergency,” said Giordano. These can include home equity and business lines of credit, and they are given to people who have low debt, and a solid record of responsible credit management.
Bucket Savings: Certain banks offer the ability to compartmentalise money for free in “buckets” within savings accounts. This keeps you from overspending your savings while helping you store enough money for your emergency fund, car fund, home repair fund, vacation fund, etc. “Having the different buckets, you can see exactly how close you are to your goals,” said Aguilar.