What Cash Should I Accumulate Outside an Emergency Fund?
There are two primary areas where I find it is useful to accumulate cash outside of an emergency fund: large purchases/expenses and investment related savings. As it relates to investment related savings, the purpose of holding cash is not to generate return. The purpose is to mitigate some of the risk associated with the liquidity and marketability of the investments.
Let us assume that you now have your emergency reserve built up and you discover your dream house, dream car, a great deal on a vacation, etc. Your dream house, car, or vacations are not emergencies. Do not tap your emergency fund for these. Now if your car breaks down, it may make sense to tap into your emergency fund for its repair. Or if your mechanic basically tells you that you are going to spend more repairing the car than it is worth, it may behoove you to spend 1-2 months’ worth of expenses on a second hand car and work on building up a car fund for a replacement when the time comes.
If you plan on making large purchases in a certain time frame AND have paid off high interest debts, it is probably a good idea to begin saving for these purchases once you have 1-3 months of cash reserve saved. You remember that extra 20%? Part of that could be used in these areas.
I am going to make the bold assumption that you have a rental unit that is renting with positive cash flow. What I am about to suggest will potentially reduce your return on investment. I often recommend to my clients with rental property to consider maintaining at least 3-6 months’ worth of expenses for their rental property held in reserve in addition to a maintenance expenses account. It would not be uncommon for these together to equal 6-12 months’ worth of expenses.
This buffer helps address issues relating to vacancy rates, maintenance issues, and shifts in the market. On a side note, if one disciplines oneself to have a cash reserve for each of your investment properties, you will probably be less likely to over-leverage yourself than those who do not.
Closely Held Business
Once again, what I am about to suggest will most likely reduce the on your return on investment as it relates to your business. If possible AND if you will not fall under the trap of being taxed on accumulated earnings (talk with your tax preparer/accountant regarding this), consider maintaining anywhere between 6-12 months’ worth of business expenses in reserve. If you are a startup, consider doubling this amount. Many businesses fail due to a lack of capital. Having capital in reserve gives you increased opportunity to weather storms and the ability to adapt/expand to the marketplace.
Cash Inside of My Retirement Account?
I do not tend to advocate cash or cash equivalents inside of retirement accounts to many people who are not retired (Yes, if you have inherited an IRA this could be a wonderful example of an exception). Cash/cash equivalents as an idea for long term savings seems to be an extremely poor idea. That being said, there is a time for cash in long term savings accounts: when you are close to the age or are actually required to take required minimum distributions (RMDs). It is never pleasant to be required to sell at a loss. For those who are required to take distributions when the market is down or face a 50% penalty on what they would have taken out, it is extremely unpleasant to say the least. Having cash inside of your portfolio can help deal with this risk in that when the markets are down, you would then be able to take the cash inside of your portfolio out so as not to suffer the insult to injury for RMDs in a down market. I personally would consider it reasonable to have one year’s worth of RMDs in your retirement portfolio with an additional two to four times your RMD in short term investments. This should be enough to weather most markets and still should provide the rest of your portfolio the opportunity to combat inflation.
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