Should You Have an Emergency Fund in Retirement?

If you follow my content, you have likely heard me say that every working person should have an emergency fund with three to six months of income.  Although, does this apply to retirees as well?  My goal throughout this blog is to not only one answer that question, but also cover four things you NEED to know about having an emergency fund in retirement. 

Key Takeaways:

·       Do you need an emergency fund when you’re retired?

·       How much money should you have in your emergency fund in retirement?

·       Where should you keep your emergency fund?

·       Where NOT to keep an emergency fund

Do You Need an Emergency Fund When You’re Retired?

The first thing I will review is whether you still need an emergency fund after you’ve retired.  Things begin to change when you retire as new income sources such as Social Security and pension income begin.  These are reliable income sources that would only be disrupted by large scale issues like a complete collapse in this country.  Therefore, you will have some income in retirement that can help mitigate the effects of no longer collecting a salary.   

For this reason, the need for holding an emergency fund decreases in retirement.  Instead of replacing a lost salary, the emergency fund’s purpose shifts to give you flexibility if your investments decrease in value substantially.  Therefore, I do still suggest that retirees have an emergency fund set aside in preparation for a less than ideal situation. 

Most retirees draw income from two sources, Social Security and their retirement accounts.  Throughout employment, these individuals contributed money to various retirement accounts to use one day in the future.  The issue is that the investments within retirement accounts can be volatile depending on how the funds are invested.  If there was a stock market crash or extended period of high inflation, then these funds would drop in value.  The situation could require you to take a larger than sustainable percentage from your retirement account which is where you could draw some money from the emergency fund. 

Other situations where the emergency fund could help are in the case of repairs or health-related events.  Unfortunately, house and automobile repairs can be unexpected and costly.  They are often unexpected could make a dent in your savings.  The same could be said for health-related events as these expenses can reach unreasonable amounts.  If you did not have sufficient insurance, or needed an off-plan procedure, then having an emergency fund could help lessen the effect of the cost.  Those who are not prepared for these events could end up using funds faster than expected and run out of money prematurely. 

How Much Money Should You Have in Your Emergency Fund During Retirement?

The next thing I want to cover is how much money you should keep in your emergency fund in retirement.  Although, there is no concrete number on how much you should save.  The number is dependent on each person’s situation so I will cover a few broad examples with how much I would save.  If you are unsure, then I would suggest contacting your local financial planner to assist you with determining the amount. 

Generally, I suggest that working individuals save 3-6 months’ worth of living expenses in their emergency fund.  If the occupation has variable income like a sales position reliant on commissions, then I will typically recommend 6-12 months of living expenses. 

As mentioned above, retirees have a few sources of income.  Examples include, Social Security, pensions, annuities, and income from investment and retirement accounts.  The next thing that you are going to want to evaluate is how much income you have coming in versus your expenses.  A great way to understand the relationship between the two would be through a budget where each source of income and expense are clearly listed.  If you have significantly more income than expenses, then you have less need for an emergency fund in retirement as you already have extra money each month that you can put towards these expenses.   

Another important consideration is what type of accounts are the money invested in.  A lot of the money is likely saved in pre-tax retirement accounts such as Traditional IRAs, 401(k)s, 403(b)s, and 457 plans.  You must understand that you will be subject to taxes on each distribution you take from these pre-tax retirement accounts.  Therefore, if this applies to you, then you should consider having an emergency fund in order to have more flexibility on the timing of distributions.  One strategy is to take these distributions in years with low taxable income to reduce the total tax bill, and then transfer the idle money to a savings account and slowly build that are your emergency fund.  

Where Should You Keep Your Emergency Fund?

The third thing to consider is where you should keep your emergency fund.  Ideally, it should be a place where you can earn interest on the money.  One option is a high-yield savings account which pays out more interest than a typical savings account.  I recommend that investors go online to bankrate.com to shop around and compare various high-yield savings accounts.  From there, you can choose the account you want to open, and then follow the links provided to do so. 

These high-yield savings accounts boast interest rates of between 3.4-4.25% annual as of March 7, 2023.  Therefore, let’s cover a real world example for a retiree with a $50,000 emergency fund designed to cover their next 8 months of expenses.  If the selected savings account paid 4% interest (which many do right now) then you could earn $2,000 per year in interest ($50,000*.04).  In this scenario, the retiree can likely skip future contributions to the account as the interest earned is large enough to replace it.  So, if you have an emergency fund that is collecting little to no interest then I would suggest a high-yield savings account.

A Roth IRA (retirement account) is another place you could hold your emergency savings.  The issue with a Roth IRA is that there are some withdrawal restraints.  Typically, if you’ve had the account open for at least five years, and you’ve reached age 59 and a half, then you could take distributions from the account without any tax penalty.  However, many people don’t realize that they can always take out the contributions to the account without any tax penalty.

Imagine you had a Roth IRA that you contributed $30,000 to and it’s now worth $50,000.  You could withdraw the whole $30,000 of contributions at any age without tax or penalty.  There would not be any taxes or penalty until the growth from the account began to be withdrawn.  If it were prior to age 59 and a half, then the individual would be subject to taxes on the growth and a 10% penalty for premature distribution from a retirement account.

Therefore, the Roth IRA is not the best option for an emergency fund.  Ideally, you would leave the money invested for as long as possible to take advantage of the compound interest.  You should take use a Roth IRA for the tax-deferred growth and tax-free income.  Therefore, I would recommend the high-yield savings account over the Roth IRA to hold an emergency fund.

The other option is to use the current holdings in your brokerage account as an emergency fund.  There are a few reasons that a brokerage account could be a suitable location.  For one, the account is highly liquid as you can sell your positions and withdraw the money two days later.  In addition, these accounts rarely have investment restrictions so you can purchase stocks, mutual funds, bonds, CDs, Money Market Funds, etc.  This issue is that there are tax consequences when you sell a position as it’s not a retirement account.  Therefore, if I had to rank the best locations for an emergency fund then it would go high-yield savings account, then brokerage account, and lastly a Roth IRA.

Where NOT to Keep an Emergency Fund

The last thing I need to cover is where not to keep your emergency fund.  If you want to hold these funds in a savings account, then you should avoid any that fail to provide a competitive rate of interest.  For example, a normal savings account pays about 0.5% interest, compared to a high-yield savings account that pays at least 4%.  If you had $35,000 in an emergency fund, then the savings account would pay $175 in interest compared to $1,400 in a high-yield savings account.  Therefore, this one decision could make a $1,225 difference in annual interest. 

The other thing to avoid are accounts that could result in penalties.  This would include Traditional IRA’s and Traditional 401(k)’s.  First, all distributions taken from these accounts after age 59 and a half will be subject to taxes.  In addition, any distributions taken before 59 and a half will be subject to taxes and a 10% penalty for the premature distribution.  Which is why these two accounts were not considered options in the section above.

Therefore, I hope you were able to take away a few lessons from this blog.  Ideally, each reader would determine where they want to hold their emergency fund and begin building it.  If you are still unclear or would like specific advice, then please take advantage of my Free Consultation.