Sunday, November 19, 2006

Rainy day contingency fund

Since I got my new job at The Evil Empire back in May, I've been trying to create a rainy day contingency fund, to act as a buffer should I have any dramatic unexpected expenses or a loss of income. A traditional rule of thumb is to have six months of living expenses in ready cash. A more conservative rule of thumb is to have an entire year of living expenses in ready. A "thin ice" rule of thumb would be to have enough ready cash to cover three full months of living expenses. It can be difficult to meet such a goal when you are just starting out or recovering from a financial disaster such as a bankruptcy (me), but at least you should have a goal and a plan to save enough each month to fund this contingency fund as quickly as possible.

In the past, I have always simply "planned" that I could and would use credit cards to cover contingencies. That is superficially appealing and does kind of work, but a really bad idea. Saving cash in a rainy day fund demonstrates and reinforces the kind of financial discipline needed to stay away from financial disasters in the first place. In other words, if you are able to successfully fund your contingency fund, the odds are that you won't need it. Out of the blue contingencies are rarely completely out of the blue. Usually there is some hint or "writing on the wall" that careless and sloppy thinking overlooks, and only discipline will help you see these things over the horizon and around the corner and take steps to avoid disaster before you walk blindly into it. Besides, if you are unable to manage a dirt-simple rainy day fund (cash in a money market mutual fund), you are unlikely to be even more disciplined with more sophisticated money and investment matters.

I just updated my net worth spreadsheet model to calculate how many months of rainy day contingency expenses I can cover, assumping a normal monthly expense budget. Presently I am sitting at 3.5 months of funding. I have additional net worth, but the intention is that only the rainy day contingency fund is available for contingencies. I need to get this up to six months ASAP, and even that is only a steppingstone to a full twleve months of funding.

I would have a six month fund today, but I chose to acelerate paydown of my back taxes. That was a choice I consciously made and continue to make. I am trying to balance these two competing priorities.

I expect to get to that magical six-month mark by the end of 2007.

I also made the conscious decision to maximize my contributions to my 401K retirement plan, my employee stock purchase plan, and even my standalone Roth IRA. None of these "count" as a rainy day contingency fund, but building up my retirement assets and overall net worth is just as important as a contingency fund. Once again, it is a matter of balancing the competing priorities.

I monitor my budget and actual expenses very carefully almost every day and move a little cash over to the rainy day fund whenever I see that I have managed to get ahead of budget. I also try to do the same to pay down my back taxes more aggressively. I consider the two to be roughly equal priority, although I may switch to bias a bit more in favor of saving for the rainy day fund until I get to a full six months of funding.

-- Jack Krupansky

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