Good news: you might not need to aim for a six-month emergency fund. The downside? Many people haven't even saved for six weeks.
What’s the optimal size for an emergency fund? How many months of liquid cash should you have accessible in case of job loss, illness, or other short-term setbacks? Traditional advice suggests maintaining three to six months' worth of expenses. Personally, I recommend three months for dual-income households—assuming one partner will likely remain employed—and six months for single-income families, where there’s no backup earner. However, recent findings indicate that both figures may be overestimated, backed by new insights from a major financial institution.
This institution serves 40 million customers, with 6 million using their checking and savings accounts as primary accounts. These accounts receive direct deposits and are used for bill payments, as explained by economist Fiona Grieg, the Director of Consumer Research at the Institute. The study focused on these 6 million accounts and revealed that, on average, individuals experience an income drop every 5.5 years, coinciding with a spike in expenses. In essence, people often need about six weeks' worth of take-home pay, equivalent to three paychecks, to manage these situations. This six-week necessity held true across families with various income levels.
Unfortunately, the findings also highlighted that 65% of households lack sufficient funds in their checking and savings to handle such events. Fortunately, the research also offered practical steps many can take to improve their financial situations.
Income Fluctuations Throughout the Year
On average, individuals encounter income spikes three times a year. These often align with year-end bonuses, extra hours during the holiday season, and tax refunds. Conversely, income dips occur about twice a year, typically during slow sales months or lean retail periods.
The key takeaway, as Grieg emphasizes, is to save during times of increased income, enabling you to pause savings when incomes dip. This strategy is more manageable than trying to automatically save a fixed percentage throughout the year. Currently, most automated savings programs don’t function this way, but some financial tech companies are innovating in this area. For instance, the savings app Digit (free for the first month, then $5 per month) uses algorithms based on your pay and billing cycles to determine a feasible savings amount, moving only that amount into savings. It also offers overdraft protection.
Practical Strategies for Immediate Implementation
There are several strategies you can implement to maximize savings during income spikes.
First, capitalize on months with a third Friday. Grieg notes that 80% of families receive paychecks weekly or biweekly, often on Fridays. Four months per year feature five Fridays, resulting in three paychecks instead of two. Her advice is to allocate a portion of that third paycheck to savings. This creates a buffer, as you still only need to cover one rent and one utility payment during those months.
Secondly, during the current open enrollment period for healthcare, consider pre-funding your deductible. Research indicates a 60% surge in healthcare expenses following tax refunds. The study utilized spending data, revealing that many individuals delay doctor and dentist visits until they receive tax refunds. This suggests that directing some extra income into a dedicated healthcare savings account, like a health savings account, could be beneficial if eligible.
Finally, assess your approach to tax refunds. Consider whether you need the “forced” savings created by withholdings or if you could manage to receive more with each paycheck and save it yourself. Giving the government an interest-free loan by over-withholding may not be the best financial strategy. If you find withholding effective, consider transferring half of your refund to a savings account where it’s less accessible for spending. Chase’s research indicates that by mid-year, individuals typically retain only 28% of their refunds.
If you’re not tuned into our podcast, you’re missing valuable insights from some of the most accomplished individuals!
