Daniel Ruske, CFP®, Author at Peterson Wealth

An emergency fund is a portion of money set aside to be used as a buffer in the event of an emergency or for an unforeseen expense. During the accumulation phase of life, or the years in which a household is reliant on a paycheck and actively saving toward retirement, an emergency fund provides a safety net to balance the budget during events such as loss of work, an expensive medical bill, or a car repair. In every personal finance textbook, you will find details on how to best manage an emergency fund. However, most of these texts focus on the accumulation phase of life. They aren’t focused on applying these beneficial principles to retirees. So, let’s go over the details of an emergency fund for retirees.

How much should I have in an emergency fund?

There is a rule of thumb that is used when determining how much a household should have in an emergency fund. The guidance is to have at least three to six months’ worth of expenses set aside. This can be a good benchmark to measure yourself against. But the problem with a rule of thumb is that everyone’s individual situation is different and may require more customization.

Calculating an emergency fund during retirement is different than during accumulation. For instance, the risk of losing your job when you’re retired is zero percent. However, in most cases, this does not completely eliminate the risk of income loss. You must determine, based on your own cash flow risks, what amount is right. For example, a retiree with multiple rentals and a history of renter turnover will require more cash on hand than a retiree whose only income source is from Social Security and a steady pension.

Where should you invest your emergency fund? How much cash should I have on hand?

The goal of an emergency fund is not to earn the highest return possible. It is to have the funds accessible when needed. A common place for an emergency fund to be kept is in a savings or money market account. You can do this at your preferred bank or credit union. Online banks that pay higher interest rates can also be a good choice. Any of these options will work, as long as your money is easily accessible.

Do not keep your entire emergency fund in hard cash. Having a limited amount on hand in your home is reasonable. However, there are added risks in having large sums of cash in your home.

Investing excess savings

Once you have determined the amount for a comfortable emergency fund, you may need to add or subtract from your current account. If you need to increase your emergency fund, the best way to do this is by adding a portion of your monthly income to the fund until you have the desired balance. Anytime you use your emergency fund, immediately work toward increasing it back to the desired amount.

It can also be common for retirees to accumulate large sums of cash in savings accounts. These are much greater than an adequate emergency fund requires. During the accumulation phase, the guidance is to put 15 – 20% of our income away into savings. In retirement, this mindset changes. Keeping extra savings in the bank, in excess of your emergency fund, can be a missed investment opportunity. This will hamper your ability to keep your investments up with inflation. If you have a balance in your bank account on top of your emergency fund needs and what you might reasonably spend in a short period of time, consider investing these funds for a greater opportunity for growth. You should also consider reducing income from sources such as taxable retirement accounts to avoid paying taxes on this unspent income just to have it accumulate in the bank.

A good question to ask yourself if you are in this situation is “when do I plan on spending this money?” If it is more than five years out, investing the funds in a diversified portfolio will result in greater growth opportunities. Talk to your advisor to determine the right investment allocation.

Conclusion

Though the amount and use of an emergency fund slightly change for individuals moving from the accumulation phase to the retirement phase of life, it is still an important part of a retiree’s financial household. Having too little or too much in savings for a rainy day could cost you thousands of dollars over the course of your retirement. Talk to one of Peterson Wealth Advisors’ Certified Financial Planners with your questions about an emergency fund for retirees.

Every year, around March and April, we begin to hear people talk about the big plans they have to spend their anticipated tax refund. Some plan vacations to various destinations around the world, others plan to pay off debt, or add to their savings. All too often, this anticipated windfall turns into an unwelcomed tax bill to the IRS.

We have found that many individuals may not know what goes into calculating their yearly income taxes and why they may or may not get a tax refund. This article will serve as a simple reminder of the fundamental components that determine your tax refund.

What are Tax Refunds?

Tax refunds are not gifts from the government that you receive for filing your taxes. They are a return of your dollars that you have overpaid in taxes during the year. In most cases, when you receive some form of taxable income whether it be from a pension, Social Security, or a distribution from a retirement account, a portion of your payment goes directly to the IRS, or toward paying your state income taxes. This is known as withholding. You, the taxpayer, controls how much of your payment goes towards paying the IRS and the state. Due to tax deductions, tax credits, or a miscalculation, a household may over or under withhold the required yearly income tax they owe. An over payment of taxes will result in a tax refund, and an under payment will result in owing a tax liability. So, you, not the IRS or your state government, decide whether you get a refund each year because you determine how much is withheld from each paycheck.

The amount of your tax refund or liability received at the end of the year is not a good indication of your total yearly income tax liability. For example, a large refund does not mean your taxes are low, and having to write a check to pay state and federal tax does not mean your taxes are high. Receiving a refund or paying a liability is a reconciling of the income tax dollars you are required to pay.

Tax Withholding

Tax withholding can be adjusted on income from Social Security, pensions, distributions from IRAs, and salaries. You can also make an estimated quarterly payment directly from your checking account. So, if a person is looking for a large tax refund, they should increase the amount of taxes that are withheld throughout the year and the IRS will return it to them in the form of a refund.

Does it Matter if I Over-withhold or Under-withhold?

In most cases, the goal is to withhold taxes in the amount that will result in as small of a refund, or tax liability as possible. However, incomes, salaries, and laws can all change throughout the year making it difficult to achieve the goal of a net zero tax refund or tax liability. So, is it better to overpay taxes during the year and get a refund? The answer… it depends. It comes down to preference. Individuals who prefer to receive a tax refund check during tax season should look to over-withhold. Individuals who prefer to have extra cash throughout the year, even if that means paying a tax bill come tax time may prefer to under-withhold.

There are two extremes that help explain the concept of withholding and tax refunds.

Under-withholding: A couple has a taxable income of $81,050 in 2022 and withholds nothing. Their paychecks will be higher throughout the year, but when they file their taxes, assuming no penalty applies, they will owe a federal tax bill of $9,315.
Over-withholding: A couple has the same taxable income of $81,050 in 2022 and withholds $14,315. Their paychecks throughout the year will be lower since a higher portion is going to tax withholding. Instead of owing $9,315 at the end of the year, they will receive a refund of $5,000 because they over withheld.

It is important to understand that, assuming no under-withholding penalty applies, over or under-withholding taxes throughout the year does not result in a larger or smaller total tax liability. The only difference is the timing of when the taxes are paid.

When do Underpayment Penalties Apply?

You may be thinking, “Well if the timing of my tax payments doesn’t impact the amount of total tax I pay, then I won’t withhold anything all year and invest the tax payments in a high yield investment account. I can then pay my full tax bill at the end of the year and keep the interest I earn.” This can be a reasonable strategy assuming two things. First, you don’t lose money in your investment over the course of the year, and second, you don’t pay more in underpayment penalties than you make in interest. In most cases, you can avoid an under-withholding penalty if you withhold at least 90% of the tax due for the current year, or if you withhold 100% of the previous year’s tax liability.

You Owe What You Owe

Whether you are looking for a tax refund, or you prefer to not give the government an interest free loan and plan on paying your tax liability every April, you can rest assured knowing that as long as you satisfy the minimum withholding requirements, your total tax obligation will be the same.

Daniel Ruske, CFP®

The Role an Emergency Fund Plays for Retirees