How To Be Rich

Based on previously covered information, we estimated that a family that makes $5000 each month could probably get by on $3150 each month taking into account taxes that won’t have to be paid and expenses that could be cut in a crisis situation.

But how many months of savings should you have? 1 month? 3 months? 6 months? 8 months? 12 months? All of these are current suggestion by financial gurus today. So who is right?

It depends.

I think, at a minimum, everyone should have 3 months of expenses saved just in case. Fortunately, we are not all clones of the next guy. Unfortunately, these differences also cause different needs for safely. I think the cause for extra funds required can be narrowed down to three different reasons.

1. Pay consistency. Some people work for salary, so they earn a consistent paycheck from week-to-week and month-to-month. However, many people work positions where their income is variable. Obviously, a person working on commission has a lot of variability in their income. However, people who work for an hourly-wage could also have their hours reduced and/or overtime limited which would also cause a drop in pay. Rate yourself for this reason either a 1, 2, or 3, with 1 being very consistent and 3 being very inconsistent.
2. Job security. Back in the day, a person could get a job right out of high school, work for the same company their entire life, and retire hold only one job in their life. Today, the average person holds their job for about 3 to 4 years. Sometimes, they choose to leave; other times, they are asked to leave. When companies are down-sizing, it is often the middle-management who are let go. Rate yourself for this reason either a 1, 2, or 3, with 1 being very secure and 3 being very insecure.
3. Expense consistency. There are two parts to the spending equation. The emergency money needs to protect us in case of reduced income, but also in case of increased expenses.  Rate yourself for this reason either a 1, 2, or 3, with 1 being very consistent and 3 being very inconsistent. (Note that anyone with children at home should probably score this a 3.)

Add your three ratings together and that number indicates the number of months I feel you should have reserved for a potential emergency. The best you can so is 1 + 1 + 1 = 3, so 3 months minimum.

Do you agree with my reasons? Can you think of any more? Would you change any of the reasons? I’d love to hear your thoughts.

So we talked about getting a starter Emergency Fund. $1000 as quickly as you can saved up.

But is that enough? How much is?

Different people have different definitions of that “how much” question. Many don’t put a hard dollar on it, but rather base it on your income, then a certain amount from there.

Just for an example (so the numbers work well), suppose you make $60,000 a year (which is $5,000 a month), and you subscribe to the belief that you should hold 6-months worth of savings.

It should seem obvious that if one month is $5,000, then 6 months should be $30,000. (Alternatively, if $60,000 is a full year, then $30,000 is a half year.)

But more than likely, that is wrong. Suppose you lose your job. If you are no longer receiving a paycheck, you no longer have to pay payroll taxes (like FICA of Medicare) or income taxes (federal, state, local). If you are regularly saving for the future (401(k) contributions, vacations) those can be put on hold temporarily. Other expenses can be temporarily eliminated as not being essential (entertainment, restaurants).

Sound Mind Investing suggests that for a median married family household income ($72,751 as of March 2011, the most current information today), payroll, state and federal taxes will account for about 16% of your income. In some states, you have a local tax which could be added to that. Families who make more should probably use a higher number than 16%, families who make less should use a smaller number.

Now that you have your after tax income number, SMI suggests that about 25% of that number can be eliminated from the budget, leaving 75% of the 84% as essential income. This works out to be roughly 63% of our gross income. So in our case of $5,000 earned per month, We are estimating that the essential amount is $3,150 per month. For six months, that number would grow to $18,900. Fortunately, this number is easier to attain than the originally predicted $30,000.

For some, a six month “cushion” is enough. Others may need more (eight or nine months). Some less (three months). We will tackle the time frame to save next month.

In the meantime, how much money (percentage wise) are you bringing home after taxes? If 16% for taxes too high or low for your? Or just right? How much of your net income (percentage wise) do you think you could live on? Could you eliminate 25%? Have you already curbed your spending so it is mostly essentials now? Or are you spending lavishly and can easily cut more? I look forward to reading your comments below.