Think of it as a financial runway. If all goes according to plan, you won’t need it, but having a savings cushion is one of the most fundamental aspects of any financial plan. Not only will it save you money—the next time your AC goes out in the middle of summer you won’t have to carry a balance on your credit card, it will also significantly reduce anxiety in your life.
An emergency fund should be large enough to provide for six months of living expenses. That’s not six months of your average monthly overhead, which would include everything from entertainment to retirement contributions. Your emergency savings is just six months of the essentials—rent/mortgage, food, student loan payments, gas, etc.
Unfortunately, most people don’t save. Even those who contribute to their 401(k) and invest in an IRA never establish a healthy savings cushion. In fact, a recent study of 7,000 Americans by GoBankingRates shows that 69% individuals have less than $1,000 in savings. That means that a majority of Americans cannot financially withstand unexpected expenses.
Interestingly, income has little effect on savings. According to that same survey, almost 50% of earners making between $100k and $150k a year have less than $1k in savings, and 29% of earners making over $150k a year have less than $1k in savings. To put that in different terms: half of those who make over $100k have less than 1% of their annual income saved.
Obviously, it is most difficult to save if you don’t make enough to provide for basic living expenses. But based on this survey, the actual practice of saving does not become more prevalent with higher earners. So why don’t people save? Essentially, people live outside their means and think of their retirement accounts as savings.
When you make more money, social norms create a tremendous amount of pressure to spend like your counterparts, and it’s a tough cycle to break. Compound that mentality with the incorrect assumption that investment for retirement equals savings, and the result is that people do not make saving a priority.
Retirement accounts are expensive to access—not only do early distributions from retirement accounts generally get taxed and carry a 10% penalty, they also completely disrupt long-term investment. Investing for retirement requires consistency, and if you derail that process for every financial emergency, you will never benefit from long-term growth.
Therefore, creating a financial cushion with savings is vital to financial stability, which is a concept that holds true for both high and low-income earners. Having that reserve will save you money, protect your retirement, and reduce the overall stress in your life.
Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.