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How Large of an Emergency Fund Do You Need in Retirement?

Will you still need an emergency fund when you retire? The answer, surprisingly, is YES, but it won’t necessarily function the way an emergency fund does during the working years.

How an emergency fund changes in retirement

Emergency fundThe most fundamental change in a retirement emergency fund is that it is no longer needed to cover a disruption in wages. You’ll be retired, you won’t have wages. But that doesn’t mean you don’t need to prepare for contingencies. Even though you won’t be working for a living, you will still have unexpected expenses that can disturb your financial plans and even disrupt your investments.

It can be said that the primary purpose of an emergency fund in retirement shifts from covering lost wages to avoiding disturbing your investment portfolio. You’ll have such contingencies arise, but if you have a well funded emergency fund, you’ll be able to keep your investments on the straight and narrow. (And should you use your Roth IRA as an emergency fund?) What kind of situations might arise in retirement that would require an emergency fund?

A cushion to ride out a decline in asset values

You may not need an emergency fund to cover lost wages, but there is one situation in which you may want to have it available to supplement your income. As every investor knows, the key to successful investing is buying when the market is low and selling when it’s high. An emergency fund can be used to avoid selling investments into market declines. Most retirees live at least partially on income earned on their investments, and that generally involves periodic distributions from your investment portfolio. If those withdrawals require the liquidation of assets, then they may result in the forced selling of investments at market bottoms. By having an emergency fund set up to cover living expenses during the worst of a market decline, you can avoid having to sell your investments at the worst possible time.

Health insurance deductibles on co-insurance provisions

Health costs only magnify with age, and need to be prepared for. Not too long ago health care in retirement was provided by Medicare and the plan was fairly standard. Not any more. Medicare is evolving into different types of coverage, but generally covering less than it once did. To make up for the difference, retirees also have the option to take supplemental coverage to cover much of what Medicare won’t.

Complicating the mix is that Medicare and its supplements don’t take effect until you turn 65, and many people are retiring sooner and continuing to rely on private insurance coverage. This creates a real need for an emergency fund to cover that which is not covered by insurance carriers. All health insurance plans have deductibles and co-insurance provisions. Deductibles represent first dollar expenses, as in you as the insured are on the hook to pay the first $1,000 or $5,000 or $10,000 (depending on the level of your deductible) of your medical expenses before your health insurance will begin covering you.

Less well known are co-insurance provisions. Even once your deductible has been met and your coverage begins to take affect, the insurance company “shares” costs with you through co-insurance. The co-insurance provision may require you to pay, say 20% of any expenses beyond your deductible, while the insurer pays the remaining 80%. In most cases, the co-insurance provision will terminate at a fixed point, say $10,000, beyond which the insurer will pay 100% of any covered expenses above

The takeaway here is that you will have a deductible and a co-insurance provision that you’ll need to be prepared to cover. And what ever that total is for you, you will also need to prepare for an equal amount if you have a spouse who will also be covered. Let’s say you have a $3,000 deductible, plus an 80/20 co-insurance provision, up to $10,000 (the insurer pays 80%, you pay 20%, or up to $2,000); your maximum exposure will be $5,000 (the $3,000 deductible, plus up to $2,000 on the co-insurance). If you’re married, your spouse will have an equal exposure, for a total of $10,000. This is an amount that should be covered in your emergency fund to prevent you from having to disturb your retirement investments.

For the usual collection of home and auto disasters

You may be retired, but you’ll still experience surprise disasters with your home, your car and nearly every other possession you own. Once again, a well funded emergency fund can prevent having to tap income producing investments to put out short term fires. Just as with health insurance, you can add amount to your emergency fund sufficient to cover any insurance deductibles, or to provide up front money for a hotel stay in the event a fire or storm renders your home unlivable. Insurance, after all, doesn’t always pay as quickly as we need it to, and if you have a cash cushion, you'll be high and dry until benefits take affect.

For the “boomerang kids”

If you have kids, you’ll probably want to pad your emergency fund with extra cash to handle contingencies with them. Many adult children return home—hence the term “boomerang kids”—or face any number of difficulties that they aren’t prepared for. As much as we’d like to believe that our children will be completely self-sustaining as adults, reality can and often does turn that assumption upside down. A few thousand dollars extra to cover come what may with your children may prove to be a needed addition to your emergency fund. Should a crisis develop, you’ll be able to handle it without needing to liquidate your investments.

How large should a retirement emergency fund be?

One of the complications of retirement emergency funds is that rules of thumb are harder to come by. When you rely on a paycheck for your living, you can simplify planning by establishing a fund equal to so many months income—after all, most of what you’re covering is lost income. But in retirement, you’re using the fund to cover contingencies that are of an unknown dollar amount. It will never be an exact science, but your fund should include, at minimum, the deductibles and co-insurance provisions for health insurance and auto and homeowners insurance, as well as enough to cover a major car repair (or two). And the more kids you have, the more you should have in your emergency fund.

If you don’t want to disturb your investments during a stock market drop, you may want to add in a few months living expenses so that you can avoid withdrawing investment funds at or near a market bottom. How much money you need in your emergency fund will vary with each individual, but the best approach is to consider the contingencies you’re likely to experience, then add a generous allowance that will make you prepared in the event one or more do actually happen. The ultimate purpose of an emergency fund in retirement is to protect your income producing investments. The more you have in your emergency fund, the less frequently you’ll need to tap your investments.

Photo by Lee Cannon via Flickr

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