The importance of building up an emergency fund

How do you prepare for large expenses, like medical bills, that can be unexpected? Vanguard financial planner Kahlilah Dowe and investing expert Michael DiJoseph explain the importance of building up an emergency fund. 

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  • All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial

TRANSCRIPT

Gary Gamma: Okay, back to these questions. Kahlilah, how can you plan for those unexpected expenses like a medical emergency or the need for a new car?

Kahlilah Dowe: Yes. So that’s a good question, and it’s one of the top questions that I see going into retirement: “Now that I no longer have income coming in, let’s say from earned income, what if something really unexpected comes up, what should I do?” And I think for that, it comes down to having a cash reserve. That’s the main thing. Making sure that you have enough liquidity that if those types of expenses come up, that you don’t have everything invested in the market. So that’s one thing. When it comes down to medical expenses, that can be tricky because they can be really unexpected and they could be very high. Many investors will use health savings accounts as a way to save specifically for medical expenses that may come up, and there may be some tax advantages to doing that. So that’s also one thing I’d say to consider. One of the things I noticed that retirees, or let’s say preretirees—those coming up on retirement let’s say within the next three years or so—they’ll actually have medical expenses as one of the budget line items. So you may, let’s say, just to give an example, $500, for example, $500 a month is allocated for medical expenses. And you may not have those expenses to come up every month, but it’s almost as though they’re just building up kind of a cash position just in case those things come up. So that’s a few ways that you could approach it.

Gary Gamma: Mike, Shawna from Utah writes, “I have about $100,000 that I want to keep in cash as an emergency fund if the market drops, and we don’t want to withdraw funds during the market downturn. I would appreciate suggestions of a safe and/or liquid place to put this money during retirement.” I know we can’t give advice, but I think we can kind of speak to the spirit of what she’s looking to do there.

Michael DiJoseph: Yeah. So I would say safety and liquidity are relative terms, right. We would say it’s relative to cash. So when you think about that, I’d say look at things like CDs, which are generally, up to a certain amount at least, insured by the FDIC, the federal government. And then look at what we would call money markets. So they’re maybe they’re not quite as safe as cash, but very similar. They invest in extremely short-term, extremely high-quality bonds to the extent that you could afford maybe a little bit of volatility in there. Then we would say maybe look toward short-term bonds. But, as you kind of move away from cash towards these things, you’re introducing potentially at least a little bit of volatility. But for an emergency fund, I don’t think cash is necessarily the worst place. I wouldn’t say that, again, for an emergency fund specifically, maybe you shouldn’t actually be looking for something with a better return.

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