Financial experts typically recommend that you should have the equivalent of three to six months' worth of income tucked away in an emergency fund. While that is an easy-to-calculate measure, it does not take into account other factors that influence how much money you will need. Such factors include the level of job you have, the industry you are in, how much your expenses are and what other resources you have to draw on. Your ideal emergency fund will take your overall income and expense profile into account in order to give you the best chance of managing an emergency loss of income.
Covering Your Expenses
One problem with traditional emergency fund size advice is that it addresses income rather than expenses. If you lose your job, your expenses will need to be covered. For example, if your monthly income is $5,000 and your expenses are $3,000, you only need $3,000 in emergency funding to keep you going for the month.
In lower tax brackets, your income and expenses are likely to be closer together, as more income is spent on basic living needs. In higher tax brackets, a larger percentage of income goes into savings vehicles, such as college savings, retirement plans and saving for a vacation, although the overall savings rate is in decline for all tax brackets. These outflows of cash can be deferred during a financial crisis. The goal of an emergency fund is to keep a roof over your head and food on the table.
Calculate your basic monthly living expenses, such as rent or mortgage payments, groceries, insurance and utilities. Exclude anything that you could put off for a few months if you had to. Your emergency fund should ultimately cover these expenses for several months.
Length of Emergency
You should always consider the possibility that you could lose your job and plan ahead. Once again, your tax bracket often dictates the estimated time you will need to get a new job. The overall unemployment rate as of September 2012 is roughly 7.8%. However, the more skilled your job is, the longer it may take to find a comparable job. In a lower-paying, unskilled position, there are far more options to replace your income.
For example, if you stock shelves at a retail store and lose your job, it may only take you a month or two to find a similar position. If you are the vice president of a major manufacturer, it may take a year or more. A survey conducted last year by global outplacement firm Challenger, Gray and Christmas found that 49% of surveyed unemployed job seekers had been out of work for 12 months or more. When determining the size of your emergency fund, take into account how long you think it might take you to find new employment.
Access to Credit
Although being able to draw on a credit card or other credit vehicle can help in a time of financial crisis, it is not a substitute for an emergency fund. Many consumers found their access to credit reduced or cut off after the economic meltdown in 2008. Those in lower tax brackets often have less ability to borrow. This is based on both their income and their often-lower asset base. This means that although the size of the required emergency fund may be lower than your higher-income contemporary, it is more important to have all of the funds gathered and tucked safely away. Those with more assets or credit lines to borrow against have more options to cover the shortfall.
The Bottom Line
The size of your emergency fund depends on many factors other than your income level. Those in lower tax brackets often need a smaller fund, as their job skills are more transferable. With today's high unemployment rate, however, everyone needs to work towards funding his or her emergency savings.
Photo Courtesy Tax Credits