How Is An Emergency Fund Similar To And Different From A Savings Fund?
Have you ever had an unexpected expense come up that threw your budget totally out of whack? Maybe your car suddenly needed repairs, your AC unit died right before summer, or you had medical bills that insurance didn’t cover. These surprise costs can wreak havoc on your finances if you don’t have an emergency fund set up.
On the other hand, you probably also have future goals that require saving up money over time, like retirement, buying a house, or your kid’s college education. These longer-term savings goals are important too.
So how are an emergency fund and a regular savings fund different, and is one more important than the other? Read on for a detailed breakdown of what each type of fund is for, how much you should save, and how to get started building up your emergency and savings funds.
What Exactly Is A Savings Fund?
A savings fund is money you deliberately set aside to use in the future. The timeline can be short-term or long-term. Your savings goals likely fall into a few main categories:
Retirement savings – The money you contribute to 401(k)s, IRAs, and other investment accounts meant to fund your life after retiring from work. Most people aim to replace about 80% of their working income in retirement.
College savings – Money meant to pay for a child’s or grandchild’s post-secondary education. Many families start college savings funds when a child is young and contribute regularly over the years.
Personal savings – Money for other big expenses like buying a house, taking a dream vacation, or even something just for fun like season tickets for your favorite sports team. The possibilities here are endless.
Cash cushion – A cushion of extra cash in your checking account to avoid overdraft fees if you overspend in a given month. Aim for a cushion of at least one month’s worth of expenses.
Rainy day fund – Savings set aside to cover unexpected costs like a major car repair, appliance replacement, or sudden vet bill for your pet. A few hundred to $1000 can go a long way.
Medical savings – For healthcare costs insurance doesn’t cover, like prescriptions, copays, and deductibles. An HSA or FSA helps with tax benefits.
The key thing is that savings funds let you proactively accumulate money for planned future expenses. Having separate savings accounts earmarked for specific goals can help you budget and resist the temptation to spend the money on something else.
Why An Emergency Fund Is Different
An emergency fund serves a very different purpose from your broader savings funds. The sole purpose of an emergency fund is to provide an available source of cash to tap into when an unforeseen expense arises.
Having an emergency fund means you don’t have to resort to desperate measures that will just dig you into deeper debt if something unexpected happens, like:
- Maxing out high-interest credit cards
- Taking out predatory payday loans
- Raiding your retirement accounts early and paying huge penalties
- Missing rent or mortgage payments
An emergency fund provides a financial safety net in case you lose your job, have huge medical bills, need home repairs, or any other sudden threat to your financial stability. It’s literally protection for a rainy day where your normal income is disrupted.
Most experts recommend having 3-6 months’ worth of living expenses saved in your emergency fund. This gives you breathing room to handle the crisis without devastating your finances long-term.
So in a nutshell, a savings fund is for planned future expenses while an emergency fund is your insurance policy when fate throws you a curveball. Got it? Read on for more nitty gritty details.
The Similarities Are Subtle But Important
At first glance, savings and emergency funds seem totally unrelated. But if you look closer, they actually have some subtle similarities that are good to keep in mind.
They both require saving up money – The first similarity is obvious but still worth mentioning. They both involve putting money aside instead of spending it all. Saving money gives you options and prevents living paycheck to paycheck.
They help control spending – When you have funds earmarked for specific purposes, you’re less likely to touch that money for unnecessary impulse purchases. Saving for the future requires discipline.
Interest can help them grow – Keeping your savings and emergency money in interest-bearing accounts like savings accounts, money market accounts, or CD ladders allows you to earn a bit of interest over time. That increases the value without any extra work on your part.
Budgeting is crucial – To effectively save up an emergency fund and other savings funds, you need to budget so you know exactly how much money is coming in versus going out each month. That allows you to funnel any extra into savings. Apps and financial advisors can help with budgeting.
Tax benefits are possible – Some accounts like 401(k)s, IRAs, HSAs, and 529 plans provide tax advantages that allow you to either save or withdraw the money tax-free. Look into whether these make sense for your different savings goals.
So in both cases, consistently setting aside money is key. But what matters most is being clear about what each pool of money is intended for.
How does the Federal Deposit Insurance Corporation affect emergency and savings funds?
The federal deposit insurance corporation role is crucial in protecting emergency and savings funds. It ensures that these funds are backed by the federal government in case of bank failure, providing peace of mind to individuals and businesses. This security encourages people to save and invest, strengthening the overall financial system.
Here’s How Emergency And Savings Funds Differ
Now let’s get into the major differences between emergency fund and savings fund strategies:
Purpose – An emergency fund is for unexpected costs only, while savings can be for anything – retirement, education, travel, etc. Don’t tap your emergency fund for non-emergencies.
Time horizon – Savings funds are generally long-term, with money meant to be used years or decades in the future. Your emergency fund needs to be accessible immediately if necessary.
Accessibility – An emergency fund should be kept somewhere with very high liquidity like a savings account, so you can withdraw it right away. Other savings can be invested in less liquid assets that earn higher returns over time but have penalties if withdrawn early.
Frequency of use – The intention is to only tap into emergency savings when a true emergency arises, while you utilize other savings accounts intentionally as originally planned. Don’t treat emergency funds as free spending money.
Order of priority – It’s wise to make sure you have an emergency fund established before focusing on other savings goals. The emergency cushion provides a foundation of financial security that then allows you to pursue other goals.
Employer assistance – More companies are starting to offer emergency savings programs as a workplace benefit to help employees cope with financial challenges. Retirement accounts and other financial wellness programs are also increasingly common.
Clearly defining the exact purpose of each pot of money is crucial to using them effectively.
Where To Stash Your Cash For Emergencies Versus Other Goals
Once you’ve set up different funds for emergencies versus longer-term savings, an important question is where to keep the money. You want to balance earning returns with liquidity, depending on each fund’s purpose. Here are some options:
Emergency fund – Savings accounts, money market accounts, or CD ladders are smart places for emergency funds. You’ll earn interest on the balance while still being able to access the money quickly when needed.
College savings – 529 plans let you invest money for education while enjoying tax perks. Prepaid tuition plans are another college-specific option.
Retirement savings – The portfolios offered by 401(k), IRA, or other retirement accounts let you invest aggressively for growth thanks to the long time horizon.
Medical savings – For healthcare costs, an HSA enables tax-free contributions and withdrawals. FSAs are another choice but with a “use it or lose it” annual limit.
Large purchases – High-yield savings accounts work well for short-term savings goals like buying a house or car within the next couple years.
Cash cushion – Keeping your cash cushion in an easily accessible checking account prevents overdrafts on your monthly expenses.
Think about your timeline, liquidity needs, and tax strategy when deciding where to stash cash for different goals.
How Much Should You Have In Emergency Versus Savings Funds?
As a general rule, here’s how much experts recommend setting aside in different accounts, as a percentage of your income:
- Emergency fund – 3-6 months of living expenses. Focus on this before other savings goals.
- Retirement – 10-15% of your gross income per year. Max out employer matching funds first.
- College – Varies but can start with 10% of projected costs. Scholarships and financial aid will offset.
- Medical – At least $1,000 to cover deductibles, copays, medications. More if you have chronic conditions.
- Large purchases – Depends on the item. Come up with a monthly savings goal to buy it outright in 1-3 years.
- Cash cushion – 1 month’s worth of expenses as a minimum, or up to $5,000 for high spenders.
Don’t let the percentages overwhelm you. Even small amounts add up over time. The key is to start somewhere and increase the amounts as your income grows. Which brings us to…
Tips For Starting Your Emergency And Savings Funds
If all this talk of emergency funds and goals-based savings accounts sounds intimidating, don’t sweat it. It doesn’t need to be complicated to make progress. Here are some tips to get started:
Make (and stick to) a budget – Getting serious about a budget is the crucial first step to find extra money you can save each month. Every dollar gets a job.
Open separate accounts – Have dedicated savings accounts at your bank for different goals like “Emergency Fund” or “Dream Vacation Fund.” This keeps things organized and prevents borrowing from one fund to cover another.
Automate it – Set up automatic recurring transfers from your checking account to the various savings accounts. Pay yourself first before spending temptations hit.
Start small – Don’t feel like you have to save thousands right off the bat. Even $20 or $50 per month adds up. Focus on building the habit.
Increase slowly – Once automatic transfers become a habit, bump them up gradually whenever you can. Small incremental increases are easy to manage.
Build up emergency fund first – Having 3-6 months of living expenses available prevents having to raid retirement or college savings when an unexpected crisis arises.
Celebrate milestones – Periodically track your progress and celebrate hitting savings milestones like $1,000 or $5,000. This provides motivation to keep going.
See? You’ve totally got this! Stay focused on the short term goals and don’t get overwhelmed thinking about 20+ years down the road. Developing smart money habits now sets you up for financial security in the future.
An emergency fund and a savings fund serve complementary purposes. The emergency fund is for unexpected expenses that threaten to derail your finances. Savings funds are for planned future expenses like retirement, college, travel, and discretionary purchases.
While they have some high-level similarities, like requiring consistent contributions and allowing interest accumulation, their intended uses are very different. The emergency fund acts as your financial safety net when you lose income or face surprise bills. Savings funds enable you to proactively accumulate money for major life goals with longer timelines.
With some budgeting diligence and separate accounts set up to keep the money earmarked for specific purposes, anyone can start building their emergency cushion and savings funds simultaneously. The important thing is to start somewhere, stick with it, and seek help from financial advisors or money management tools if you need guidance on amounts to save.
Consistently setting aside money each month is the key habit. Build your emergency fund first so you have that foundational financial security, then you can expand to focus on retirement accounts, college savings plans, and funds for other goals. The more you automate the process, the easier it becomes.
Stay disciplined about only tapping into emergency funds when a true emergency hits. Let your other savings accounts do their jobs funding the future purchases you planned for all along. With the right preparation, you can handle unexpected hurdles without derailing your overall financial plans!