The internet is suffering no shortage of opinions on the subject of how much cash savings you should have. Professional advisors vary widely on opinions of the amount someone should have, and to varying degrees, they’re all right. Like the vague concept of “risk”, the exact amount of cash savings that is right for you is highly individualized. We thought it might be helpful to frame the decision, and let you set a goal informed by your particular needs.
Distinguish Purposes for Cash
When people ask how much cash they should hold, they’re typically thinking about their safety net – the amount they should have set aside for an emergency. But cash savings has other purposes, too. We know of one investor who has a substantial amount of cash set aside in case she needs to quit her high-stress job in a hurry, and then spend some time decompressing. A more mundane example: it’s best to satisfy any major purchase or expense that you expect in the next 12 months with cash. Investing money in stocks or bonds (stock or bond funds) that is allocated for a near term expense is short-sighted. If you have an identifiable purchase, expense, or job change goal, begin by quantifying that amount and setting it aside.
Safety Net Cash – How Many Months?
Next is safety net cash. This is true emergency money – savings intended to get you past the unforeseeable, possible loss of income. Most opinions you’ll run across express this in months-worth of living expenses. Start by taking your monthly after-tax pay, and subtracting regular savings, gifts, and obvious discretionary expenses like vacations. Add irregular insurance premiums and, in the case of high-deductible health insurance plans, your annual deductible. The amount you should be left with will be close to your actual monthly necessary expenses.
When deciding how many months of necessary expenses to cover, begin by estimating when you’ll have income again. If for instance, long-term disability is a concern, begin by setting aside enough months of necessary expenses to cover your “elimination period.” The elimination period is the time frame that must pass between when you file a claim for benefits and when payments begin, as stipulated by private disability policies. Normally, this is 90 days, but it varies and is worth knowing. The Social Security Administration will also pay benefits in the event of disability, and typically takes 3 to 5 months to determine eligibility.
If a job loss is your major concern, begin by determining how long it will likely be for you to find a job that replaces your prior income. Job search time is a function of marketable skills, age (sad, but true), the strength of the job market, and your expected income. The strong job market at this writing is a benefit for all workers, and means that your search might be shorter than in other years.
What’s Your Number?
Here’s the simple formula we’re suggesting:
Planned purchases & expenses + (months of necessary living expenses x projected months of income lost) = the amount of cash savings. Whether it equates to 3, 6, or 12 months of expenses is less relevant than accounting accurately for your expected dollar needs.
Alternatives to Cash
Interest rates on bank savings accounts are getting better, but they are still low. So having a lot in cash may not be desirable. And even if you’re diligently building toward the amount of cash you need, it might still take years to accumulate enough to meet your goal. In addition to cash savings, consider the following alternatives, presented in order of desirability:
- Home Equity Line of Credit
- Life insurance cash value loan
- 401(k) loan
- 90 day IRA withdrawal
The best alternative may not be an either-or, but a both-and. For example, we would often discourage a 401k withdrawal except in emergency situations. However, it can be a reasonable back up if you find yourself in financial hardship.
Like most other financial decisions, the right amount of cash to hold is highly subjective. In this blog we’ve laid out a way of determining how much you need, but we haven’t covered every potential expense. Hopefully you’re now thinking of additional expenses you need to cover, or can do without.