By Matt Andersen, CPA, Founder of MD Andersen, CPA, PA
We have long known that Americans aren’t big on saving money. Our tendency towards optimism, particularly during strong economic times, often leads us to take on more risk and deplete our cash, even when we know we should be saving for that inevitable rainy day. The arrival of COVID-19 didn’t feel so much like a rainstorm as it did a tsunami of economic disaster. While its path of destruction is not fully realized, it comes as little surprise that individuals and businesses began hoarding cash and dramatically cut back on spending.
The question on the minds of many remains. Is this the wake-up call we all needed? Is our desire to cling to cash a temporary reaction or is the emergency savings fund changed forever?
There is no doubt that COVID-19 affected how we think about money and our “rainy day” funds. Pre-pandemic, emergency savings funds were thought of as sources for quick cash in a pinch. It was a way to pay for that unexpected car breakdown or medical expense. The emergency no one anticipated was a shift in the global economy so large, it would destroy jobs and reduce income at a rate not seen since the Great Depression. Now instead of using emergency funds for that occasional unpleasant bill, they are a source of cash for lost income, and used to pay for essential, everyday expenses over several months.
This is a dramatic shift in how we think about the use of savings. It signals a need to increase cash reserves for times when we need them to serve as a primary source of income. However, it is important to note this use of savings is not all that different from before the pandemic. Most people who have taken time off of work, encountered a catastrophic external event, or had some other financial disaster, have had the experience of living off savings. It always goes faster than you expect and, for many, can result in a vicious cycle of debt once it’s gone.
So how much cash do we really need?
Traditional wisdom generally says an emergency fund should have 3-6 months of readily available cash reserves. Those who have experienced the negative economic effects of COVID-19 likely needed the full six months if not more. There are several other factors at play, including your age, how close you are to retirement, and whether or not your income tends to fluctuate over time. In the case of many business owners, our firm has long advocated for holding a full year’s worth of cash in a personal emergency fund, and having access to at least 3-6 months of operating expenses available to the business via lines of credit, cash on hand, and accounts receivables.
We get this sounds a bit extreme and let us be the first to acknowledge that, yes, we realize these warnings sound very CPA-like. As Certified Public Accountants, we are bound to protect the financial interests of our clients and have a reputation for avoiding risk. However, this advice does not come from a fear of making risky investments. If you have paid off all debt, have significant cash reserves, investments outside your business, and cash flow is still strong, why not add risk exposure?
The reason we advocate for larger emergency funds, particularly in the case of entrepreneurs, is that we know it works. In our experience, business owners who build companies that last often hold ridiculous amounts of cash to weather unexpected storms.
This leads us to the inevitable question many of our clients ask. How exactly am I supposed to build such a large emergency fund? We all have expenses and can’t simply flip a switch and start saving mass quantities of money.
Building your cash reserves is a marathon, not a sprint. It requires consistency and dedication, even if it means forgoing other seemingly responsible actions such as making accelerated debt payments. When it comes to emergency funds, it’s all about prioritization. If you use cash reserves to pay down debt, unexpected losses of income can lead you back to the same debt cycle, borrowing more money to pay your bills.
The good news is there are plenty of free resources that can help you strategize and increase your emergency fund. A quick Google search can guide you toward high-yield savings accounts and other investment vehicles suited to hold emergency cash. Banks can also help you establish automated checking-to-savings transfers and enroll in programs to round up purchases and save with every transaction. This calculator from Nerd Wallet is another helpful tool that helps determine savings goals and strategies regardless of where you are starting financially.
The hard truth is, despite our rapid increase in savings, our economy remains vulnerable as more and more people lose jobs and rely on emergency cash. We are still far from certain how and when the situation will recover. Our hope is the lessons learned about the importance of emergency funds will not be forgotten, particularly among those entrepreneurs who create opportunities for others. If you have specific questions about your own savings strategy, you can book a coaching call online to find the emergency fund that works for you.
Matt Andersen, CPA loves analyzing data, people, and businesses. He is passionate about helping entrepreneurial-minded clients achieve their goals, keep more money in their pockets, and live a higher quality of life. In addition to tax and accounting services, Matt provides one-on-one coaching for various topics including lifestyle entrepreneurship, advanced tax planning, and new business creation.