Monthly Archives: May 2016
Along with dynamic your oil each three,000 miles and checking your child’s trick or treat bag for weaponized apples, the common recommendation to form associate degree emergency fund is too prudent. All you wish is associate degree objective understanding of risk to comprehend that there ar much better places to place your cash thanassociate degree inert account that can’t enrich you.
The most recognizable personal finance mavens are almost unanimous in their advocacy of the emergency fund as a vital part of any common-sense financial plan.
Their recommendations differ only on size three months six months perhaps eight months worth of living expenses are enough to accommodate whatever misfortune might befall you. But to what end? And do people really listen, or are these just empty dicta written to take up space
Don’t match it
First of all, exactly how much money are we talking about here?
Looking at the most recent statistics, per capita income in the United States was $55,836.80 in 2015 according to the World Bank, and the personal savings rate of disposable income was 5.3% in August, 2016, according to the Bureau of Economic Analysis.
Assuming an effective tax rate of 20%, and using the conservative recommendation to sock away eight months’ worth of living expenses, that means it’d take about $30,000 to create a sufficiently stocked emergency fund. Even using the three months’ figure, you’d still need $11,000 for an emergency fund that passes the muster of convention. If those numbers sound high, or even if they don’t, understand that in the U.S. the average household credit card debt was $16,048 in March, 2016. Americans are also carrying a cumulative $1.2 trillion in student loan debt, which dwarfs the credit card debt on a per borrower basis.
In other words, the math doesn’t come close to working out on emergency funds. If the experts are going to issue a blanket recommendation to millions of people that they should all create a buffer to tie them over in unforeseen circumstances, it would make far more sense to say, “Instead of amassing an account that pays you 0%, or a few basis points above that, maybe you should focus on closing out an account or two that’s costing you 15%.”
Clear Debt First
It’s easy to insist that emergency funds are crucial for everyone, while ignoring just what position the average household’s finances are in. If you’re carrying credit card debt, student loan debt, or both, then building cash reserves for the purpose of anything other than paying down those debts should be the last thing on your mind. Of course, the more economically you live and the more money you make, the better positioned you are to create an emergency fund. But this is where the irony lies. Because, as a rule, the folks who are diligent enough to live without consumer debt usually pay their bills on time. They do not impoverish themselves so they or their offspring can attend college, and they do not spend extravagantly. They are also the ones who are going to be least prone to emergencies, and thus least in need of any emergency fund.
Perhaps you’re worried about the transmission falling out of your car, which would necessitate a $3,000 repair. If you feel that the prospect of this problem warrants creating an emergency fund, but you’re already carrying enough debt to cover three or four transmission replacements, the sad news is this: your emergency has already begun. It began several thousand dollars ago.
If you’re going to minimize risk for yourself or your family a noble task in and of itself society has already developed several methods for doing so, any of which you can use to your advantage. Worried about a debilitating illness or injury? We have health insurance for that. Not only will a comprehensive health plan cost less than a regulation emergency fund, the former is earmarked for a specific purpose. The same goes for the fear, however irrational, of a cataclysmic car accident. Again, we have auto insurance. If you’re really that concerned about worst case scenarios, spending a few dollars raising your coverage limits to the maximum makes far more sense than does spending thousands more on an emergency fund.
Many people who have saved consistently for retirement have trouble making the transition from saver to spender when the time comes. Careful saving– for decades, after all – can be a hard habit to break. “Most good savers are terrible spenders,” says Joe Anderson, CFP, president of Pure Financial Advisors, Inc. in San Diego.
It’s a challenge most Americans will never face: More than half (55%) are at risk of being unable to cover essential living expenses – housing, healthcare, food and the like – during retirement, according to a recent study from Fidelity Investments.
Even though it’s an enviable predicament, being too thrifty during retirement can be its own kind of problem. “I see that many people in retirement have more anxiety about running out of money than they had working very stressful jobs,” says Anderson. “They begin to live that ‘just in case something happens’ retirement.”
Ultimately, that kind of fear can be the difference between having a dream retirement and a dreary one. For starters, penny-pinching can be hard on your health, especially if it means skimping on healthy food, not staying physically and mentally active, and putting off healthcare. (For more, see 7 Signs You’re Spending Too Little in Retirement.)
Being stuck in saving mode can also cause you to miss out on valuable experiences, from visiting friends and family to learning a new skill to traveling. All these activities have been linked to healthy aging, providing physical, cognitive and social benefits. (For more, see Retirement Travel: Good and Good for You.)
One reason people have trouble with the transition is fear: in particular, the fear that they will outlive their savings or have medical expenses that leave them destitute. One thing to keep in mind that spending naturally declines during retirement in several ways. You won’t be paying Social Security and Medicare taxes anymore, for example, or contributing to a retirement plan. Plus, many of your work-related expenses – commuting, clothing and frequent lunches out, to name three – will cost less or disappear.
To calm people’s nerves, Anderson does a demo for them: “running a cash-flow projection based on a very safe withdrawal rate of 1% to 2% of their investable assets. Through the projection they can determine how much money they will have, factoring in their spending, inflation, taxes, etc. This will show them that it’s OK to spend the money.”
Another reason some retirees resist spending is that they have a particular dollar figure in mind that they want to leave their kids or some other beneficiary. That’s admirable – to a point. It doesn’t make sense to live off peanut butter and jelly during retirement just to make things easier for your heirs. (For more, see Designating a Minor as an IRA Beneficiary.)
“Retirees should always prioritize their needs over their children’s,” says Mark Hebner, founder and president of Index Fund Advisors, Inc, in Irvine, Calif. “Although it is always the desire for parents to take care of their children, it should never come at the expense of their own needs while in retirement. Many parents don’t want to become a burden on their children in retirement and ensuring their own financial success will make sure they maintain their independence.”
Since there’s no magical age that dictates when it’s time to switch from saver to spender (some people can retire at 40 while most have to wait until their 60s or even 70+), you have to consider your own financial situation and lifestyle. A general rule of thumb says it’s safe to stop saving and start spending once you are debt-free and your retirement income from Social Security,pension, retirement accounts, etc. can cover your expenses and inflation.
Even if you find it hard to spend yournest egg, you’ll have to start cashing out a portion of your retirement savings each year once you turn 70½ years old. That’s when the IRS requires you to take required minimum distributions, or RMDs, from your IRA, SIMPLE IRA, SEP IRA or retirement plan accounts (Roth IRAs don’t apply) – or risk paying tax penalties. And these aren’t trivial penalties: If you don’t take your RMD, you will owe the IRS a penalty equal to 50% of what you should have withdrawn. So, for example, if you should have taken out $5,000 and didn’t, you’ll owe $2,500 in penalties.
If you’re not a big spender, RMDs are no reason to freak out. “Although RMDs are required to be distributed, they are not required to be spent,” Charlotte A. Dougherty, CFP, of Dougherty & Associates in Cincinnati, points out. “In other words, they must come out of the retirement account and go through the ‘tax fence,’ as we say, and then can be directed to an after-tax account which then can be spent or invested as goals dictate.”
As Thomas J. Cymer, DFP, CRPC, of Opulen Financial Group in Arlington, Va., notes: If individuals “are fortunate enough to not need the funds they can reinvest them using a regular brokerage account. Or they may want to start using this forced withdrawal as an opportunity to make annual gifts to grandkids, kids or even favorite charities (which can help reduce the taxable income). For those who will be subject to estate taxes these annual gifts can help to reduce their taxable estates below the estate tax threshold.”