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If I asked you to list the biggest risks to your assets, I’m sure malpractice lawsuits would appear near the top. But lawsuits are only one of the many catastrophes that put your assets at risk. Whether you’re preparing for a natural disaster, a potential disability, or even death, you should seriously consider asset protection. Step one? Establish an emergency fund.

Simply put, an emergency fund is a highly liquid account which contains safe short-term investments that you can access quickly. It is completely different than your checking and retirement accounts and should be used only for unexpected large cash needs.

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How much money should I have in my emergency fund?
While there is no “one size fits all,” you should keep a few things in mind when creating an emergency fund. If the fund is too small, you risk not having enough cash on hand during a financial catastrophe. If it’s too large, you risk not investing the money elsewhere for potentially higher returns. The first step is to calculate how much you are spending each month. Once you know that, I suggest two options. If you spend much less than you make, have multiple sources of income, have passive monthly income, or your spouse works, consider having 2 to 4 months of income in reserve. If, on the other hand, you spend a large proportion of your income, have only one source of income, you have no passive income, or your spouse does not work, consider having 4 to 6 months of income in the fund. It is also important to check your disability policy and see when your policy starts paying benefits. Keep an emergency fund in an amount equal to at least the number of months until your disability benefits kick in.

How do I build an emergency fund?
First, stop investing in your retirement accounts. You read that correctly. While it’s obviously important to save for retirement, concentrate on building your emergency fund now so that you never have to dip into your retirement accounts for immediate financial needs. Also, create a completely separate account for your emergency fund instead of integrating it with your checking account. This way you won’t be tempted to dip into the fund for daily expenses.

What should the emergency fund be invested in?
First, realize that an emergency fund is not an investment and it should not be considered a part of your investment portfolio. I’ve seen physicians who use their stock market “play” money and say, “If something happens, I’ll just use that as my emergency fund.” Well, what if you became disabled in 2008 while your stocks were sinking? Your emergency fund should be highly liquid and should have minimal fluctuation in principal value. Appropriate investments include money market accounts at banks, short term CDs (less than three months), money market mutual funds, and short term bond funds. Money market accounts and CDs provide an extra layer of protection because they are FDIC insured whereas mutual funds are not. So if you use a money market mutual fund or a short term bond fund, you should know that you are taking on some extra risk.

What else should I know about emergency funds?
While loans (via a home equity line of credit or credit cards) may provide instant access to funds, you better be 100% sure that you can pay back those loans soon after your financial crisis has passed.

If you tap into your emergency fund, the process of building an emergency fund starts over again.  In other words you should always have an emergency fund. You can think of it as a long term account used only for short term purposes.

Finally, use your retirement accounts as a last resort. While it’s possible to take hardship withdrawals from 401k plans and early distributions from IRAs, you may be subject to taxes and penalties. Also, if your financial emergency is temporary, you’ve now compromised your retirement and tax deferred growth in those accounts.

Setu Mazumdar, MD practices EM and he is the president of Lotus Wealth Solutions in Atlanta, GA www.lotuswealthsolutions.com

 

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