A common mistake when saving for retirement is to focus all your mental energy on one number: your nest egg.
But while a large 401(k) and IRA balance is essential, it’s not a complete plan.
Without an emergency cash reserve, unexpected expenses can derail your retirement strategy, forcing you to sell assets during market downturns or even trigger unnecessary fees.
Real retirement preparation requires a dedicated cash reserve to handle emergencies that are completely predictable in the category, even if their timing remains a mystery.
Here’s how to build a safety net that protects your lifestyle and longevity.
According to an analysis by Boston College’s Center for Retirement Research, retirement is rarely a smooth financial journey (1).
Their study found that 83 percent of retirement households experience at least one unexpected expense in a given year.
For the typical household, these spending shocks amount to about 10% of their annual income.
The study identified three main categories in which these costs are grouped:
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Rainy Day Household Needs: Repairs and maintenance average about $3,300.
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Family-related expenses: Helping children or relatives, about $5,700 on average.
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Medical Care: Out-of-pocket medical expenses average about $4,100.
Although these costs are common, many retirees are not prepared.
The study reports that only 58% of older households have enough money to cover a year of predicted shocks.
Another 16% could get by by tapping into retirement accounts, but about 27% can’t get by even after depleting both cash and retirement assets.
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During the working years, many emergency expenses are compounded by job loss. In retirement, that risk goes away, but the stakes of an emergency really go up.
In retirement you can no longer “earn your way” out of a surprise bill.
When you no longer receive a salary, you have a limited ability to rebuild savings through work, which makes the size of your initial reserves an existential factor in retirement planning.
Tapping into your retirement accounts to cover a furnace repair or medical deductible creates tax and time headaches.
If you’re under 59 1/2, taking an early distribution from a traditional IRA or 401(k) can trigger a 10% penalty from the IRS on top of standard income taxes.
Even for those over 59 1/2, a large, unplanned withdrawal can push you into a higher tax bracket or raise your Medicare premiums, making that “emergency” significantly more expensive than the sticker price.
Finding the Goldilocks zone for your emergency fund is the key to long-term success.
Based on Boston College’s findings, a basic target should be at least 10% of annual income held in liquid savings, especially for spending shocks.
According to AARP, many financial advisors suggest a more robust cushion of 18 to 24 months of essential expenses. This larger buffer provides peace of mind during extended market volatility, allowing you to leave your invested portfolio untouched while the market recovers (2).
Plus, your individual circumstances play a role here, too: “Retirees with steady incomes and liquid portfolios may need less cash, while those with higher medical risk or less flexibility need more,” says certified financial planner Joon Um (3). “The goal is not to maximize cash, but to have enough on hand to avoid selling long-term investments at the wrong time.”
There is, however, too much money.
Holding excessive amounts of liquid cash can allow inflation to erode your purchasing power. AARP recommends limiting this fund to 24 months of spending so the rest of your wealth can stay invested and growing.
Your emergency reserves should prioritize liquidity first and yield second.
High Yield Savings Accounts (HYSAs) or money market accounts are the primary place to store liquid cash. They offer instant access and as of 2022 have offered better interest rates than standard checking or savings accounts.
Many money market accounts also offer higher interest rates and affordable cash. These accounts invest in short-term securities such as Treasury bills (T-bills).
You can also buy Treasury bills directly from the Treasury through its TreasuryDirect website. These securities are issued for terms ranging from 4 to 52 weeks.
However, it’s worth noting that this process requires some work, and you can get the same benefit by holding a money market account or an ETF that invests in government securities.
The CFPB points out that keeping these funds in a dedicated account, separate from your daily spending, creates a psychological boundary that protects the money for its intended purpose (4).
If you want to secure your retirement today, follow this three-step framework:
First, define your “essential” number to calculate your monthly benchmark for housing, utilities, food, insurance and medical costs. Multiply this by 18 or 24 to find your target range.
You can use the 10% of income benchmark from the BC study as a secondary check to ensure you are covered for non-essential shocks such as helping family members.
Second, create a multi-bucket structure so you don’t put all your money in one place.
Set up small instant-access buckets for savings, a larger bucket of liquid in a high-yield savings account or money market account, and a top-level bucket of short-term government bond ETFs or CDs to prevent being forced to sell long-term investments at the wrong time.
Step three, automate your savings. If you’re still working, take advantage of SECURE 2.0 provisions like Linked Retirement Emergency Savings Accounts (PLESAs), which allow for dedicated emergency caching within a retirement plan.
If you’re already retired, schedule a small transfer from your source of income to your emergency fund until it’s full.
Combine the bucket method with preventative measures like annual home maintenance and Medicare cost-sharing reviews to ensure that when a shock does occur, it’s a minor inconvenience rather than a financial disaster.
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Center for Retirement Research at Boston College (1); AARP (2); CNBC (3); Consumer Financial Protection Bureau (4)
This article provides information only and should not be construed as advice. Offered without warranty of any kind.
