An emergency fund is essential, no matter your age. But in retirement, not having one can be costly. Having an emergency fund means you don't have to tap your IRA, 401(k), or other taxable assets to pay for unexpected expenses. And it can also ensure you won't have to go out and get a job if you're retired.
The key to staying on budget as a retiree is to estimate an adequate amount for your emergency fund. You'll also need to identify the right type of account to keep it in.
Why Do Retirees Need an Emergency Fund?
Emergency funds are meant to be used for unexpected costs. That way, you don't have to sell off assets or run up debt to cover them. During your working years, an emergency fund is also a source of backup cash. This can be helpful if you lose your job or can't work because of a temporary disability.
Heading into retirement, an emergency fund serves additional purposes. These can include:
Protecting Long-Term Investments
When the market's down, withdrawing money from your investment accounts could mean taking a loss. This can happen during a recession. If you have money in emergency savings, you could withdraw that first to give your portfolio time to recover.
Help in Covering Medical Costs
Emergency savings can fill the gaps when it comes to funding health care. Consider the case of a 65-year-old couple retiring in 2020 without employer-provided retiree health coverage. According to Fidelity, this couple might expect to spend $295,000 on health care. This doesn't include long-term care. An accident, unexpected diagnosis, or serious illness could result in medical bills piling up. This is even more true if insurance or Medicare doesn't cover the full cost.
Easing the Loss of a Part-Time Job
If you supplement your income with a part-time job or your spouse is still working, an emergency fund can provide a short-term income source if that job is lost.
Covering Age- or Health-Related Home Improvements
If you run into mobility issue, you may need to make changes to your home. You may need to add a ramp, install grab bars in a bathroom, or make hallways and doors wider. An emergency fund can keep you from having to drain your pension, 401(k), or IRA to do so.
How Much Should You Have in an Emergency Fund?
Three to six months' worth of expenses is the rule of thumb for emergency funds. The amount you may need as a retiree, though, depends on a few other factors. These include:
- Your basic monthly expenses. This includes how much you pay for your mortgage or rent, home maintenance and upkeep, food, utilities, transportation, credit cards and other debts, and health care.
- Your monthly retirement income. This includes Social Security benefits, pension payments, regular withdrawals from investment or retirement accounts, and annuity income.
- How insulated your portfolio is against risk. Keep in mind how your assets are allocated.
- What you already have available in liquid savings. These may be savings accounts, money market accounts, or CDs.
To approximate a minimum amount for your emergency fund, multiply your total monthly expenses by the number of months you want to cover. For instance, let's say you want a 12-month emergency fund and your monthly expenses are $5,000. That means you'd need $60,000 set aside for an emergency savings account.
What if most of your retirement funds are in cash or other guaranteed investments? This means they would not be impacted by market downturns. In that case, you may not need an emergency fund much larger than the recommended three to six months’ expenses.
If, however, a large portion of your retirement funds are invested in securities, like stocks and bonds, a sizable emergency fund is prudent. This will help protect you from withdrawing invested funds when the market is down.
Consider talking to a financial advisor about asset allocation in retirement. In the best case, your portfolio is less exposed to risk once you’ve retired. That way, you're able to weather market downturns without experiencing significant losses.
Where Should You Keep Your Emergency Fund?
Money in an emergency savings account needs to be ready when you need it. You also don't want it to be subject to market volatility, liquidity problems, or withdrawal fees. For these reasons, FDIC-insured (or NCUA-insured) accounts are good choices.
High-Yield Savings Account
High-yield savings accounts offer easy access to your money. They also often earn above-average interest rates on deposits. These accounts can be linked to a checking account for easy transfers; they are available at traditional banks, credit unions, and online banks.
Online banks often pay higher rates to savers than traditional banks do. But you may sacrifice branch or ATM access.
Money Market Account
A money market account is a bit like a savings account. You earn interest on your money, and funds are easy to access. The difference is that some money market accounts also allow you to write checks; some may even allow you to withdraw funds using an ATM or debit card.
Savings accounts can often be opened with as little as $1. But money market accounts may require a minimum deposit of hundreds or thousands of dollars to open.
Roth Individual Retirement Account
A Roth IRA is used for retirement savings. But it can also be a good choice to house an emergency fund. As a designated retirement account, you don’t pay tax on any earnings, like interest or dividends, within the account. Unlike a traditional IRA or 401(k), you don’t have to pay taxes on qualified withdrawals; contributions can be withdrawn tax- and penalty-free at any time.
Also, required minimum distributions (RMDs) don't apply during the account owner's lifetime. That means there’s no need to start taking RMDs at the traditional RMD starting age of 72. (It's 70 1/2 if you reached age 70 1/2 before January 1, 2020.)
A qualified withdrawal is one you make after you turn 59 1/2. Also, the account needs to have been open for five years.
Having a savings or money market account in a Roth IRA can be a good move if you have—or want to have—a very large emergency fund. Otherwise, interest and dividends could create a large tax burden.
But you can’t make new contributions into a Roth IRA unless you or your spouse are still working or earning income. The annual contribution limit for a couple aged 50 or older with at least one spouse working is $14,000 in 2020 and 2021. This amounts to $6,000 in regular contributions and $1,000 in catch-up contributions for each spouse. And keep this in mind: If you open a new Roth account, you need to wait at least five years to withdraw any earnings without being penalized.
Let's say you're a retiree who already has a Roth IRA at one institution; for instance, with a broker. But you want to allocate some of those funds for emergency savings with another institution. Perhaps an online bank offers a higher interest rate.
In this case, you could transfer an amount from the first Roth into a high-interest savings or money market account in a new Roth IRA at the other institution. Funds that are transferred from one Roth to another are not considered new contributions. This means they are not subject to the five-year rule. By doing this, you get the higher savings rate at the new bank. And, you don't lose the tax benefits of your funds being in a Roth IRA.
If you keep an emergency fund in a Roth IRA, keep it separate from your general retirement funds. Put it in a money market or savings account within a Roth, for instance. Use it for emergencies only. And be sure you don’t invest it in anything that could lose value or be hard to access; these could include mutual funds (which can lose value), or an annuity with a surrender period and withdrawal penalties.
Where You Shouldn't Keep Emergency Funds
Some accounts aren’t meant to give easy and penalty-free access. That means they aren't good choices for an emergency fund. These types of accounts include:
A Certificate of Deposit (CD) Account
A certificate of deposit account is subject to an early withdrawal penalty for taking money out before the CD matures. This could eliminate most or all of the interest you earn. In some cases, it could even cut into your principal. The same applies to annuities with a surrender period as well.
Avoid any account in which your funds aren’t guaranteed. In other words, any type of security, such as mutual funds, stocks, and bonds, are out of the question. Plus, they can have liquidity issues.
A Traditional IRA
A traditional IRA may not be the best choice for emergency savings either. This is even more true if you’re younger than 59 1/2. You will pay taxes on the entirety of any amount you withdraw, no matter your age. And making an early withdrawal (before 59 1/2) triggers an additional 10% penalty. unless you qualify for an exception, such as total and permanent disability.
When deciding where to keep emergency savings before and during retirement, prioritize accounts that guarantee your money, are penalty-free, and are easily accessible.
- Retirees benefit from having an emergency fund; this is true even if they have other assets and income streams.
- Having three to six months' worth of expenses is only a guideline. You may need to adjust this amount to account for higher health care costs or increases in living expenses.
- Emergency funds are best located in savings and deposit accounts that are liquid and easy to access.
- Using certain retirement assets for emergencies, such as a traditional IRA or 401(k), could lead to tax consequences.