How Much Cash Do You Really Need?

Getting financially fit--and staying that way--isn't something you can knock off on a Saturday morning. Rather, like any worthwhile project, it's a goal that's best accomplished as a series of smaller steps.

I developed my 2017 financial to-do list as a means of helping you spread all of the important financial-management tasks throughout the year. So far in 2017, I've tackled evaluating your savings rate and optimizing retirement-plan contributions (January); rebalancing and getting organized for tax season (February); making IRA and health savings account contributions (March); and organizing your financial records (April).

On the docket for May: right-sizing your cash cushion. Unexpected expenses can crop up no matter your life stage, making it essential to hold liquid reserves--apart from your long-term retirement assets--to defray them.

But how much cash is enough? That's more complicated than it sounds. While the financial-planning textbooks suggest that people stash three to six months worth of living expenses in true cash instruments, the right amount of cash varies by individual; life stage, career type, and access to other sources of liquidity, among other factors, all play roles. A 55-year-old independent contractor with two kids in college obviously needs more cash on hand than a new grad who's renting an apartment with three friends. On the other hand, the 55-year-old may have more ready access to cash than the new grad--via a home equity, for example; that means he may not need to stash quite as much in true cash instruments in the bank.

As you assess your cash holdings and determine the appropriate allocation, here are eight questions to ask. For another read on right-sizing your emergency fund, check out HelloWallet's handy Emergency Savings Calculator.

Question 1: What is your life stage? The key swing factor in determining your cash allocation is whether you're still working or retired.

If you're still working, the main role of your cash cushion is to tide you through job loss. Secondarily, you'll want to hold cash so that unanticipated expenses don't force you to raid your long-term assets--or turn to unattractive forms of financing like credit cards--to meet your living expenses. It's reasonable to use three to six months worth of living expenses as a starting point when setting your cash allocation. You can then refine that number based on your estimation of your job security, how long it would take you to replace your job if you lost it, and so on. (The following questions take a closer look at those issues.)

If you're retired, the threat of job loss is obviously no longer an issue. But it's still wise to hold a cash cushion. Unanticipated expenses like emergency car repairs and big vet bills can crop up in retirement just as they did while you were working, and it would be a shame to have to raid your long-term investments to cover them.

More important, retirees need to hold cash to tide them through downturns in their long-term portfolios. Knowing that their near-term income needs are covered can also help retirees ride out volatile times with their long-term portfolios. This article details the bucket system for managing a retirement portfolio; the system employs dedicated cash reserves, then takes on more risk with longer-term portions of the portfolio.

As a general rule of thumb, my bucket portfolios assume one to two years' worth of living expenses in cash holdings (bucket 1). When I say "living expenses," I mean assets that are needed from the portfolio and are not being supplied by certain sources of income such as Social Security or a pension. To use a simple example, let's say Carly needs $65,000 in total living expenses in retirement. She's receiving $28,000 from Social Security, so she'd hold anywhere from $37,000 (one year of portfolio withdrawals) to $74,000 (two years worth) in cash instruments.

Question 2: How stable is your income? If you're still working and earning an income from a job, the next factor to consider is how stable your earned income, or human capital, is. At one end of the spectrum would be people who have extremely stable incomes with minimal chance of disruption--tenured college professors, for example. Such individuals, while a rare subset in today's economy, can get by with a cash cushion that's on the low end of the three- to six-month range. At the other end of the spectrum are workers with more volatile cash flows from their jobs: commissioned salespeople and small business owners, for example. In such cases, holding even more than six months worth of living expenses is prudent.

Independent contractors--a growing share of the population--should also take a conservative tack when it comes to liquid reserves, as work/income disruptions can be frequent and sustained. This article takes a closer look at financial and retirement-planning considerations that affect contractors, including the need to hold a higher stake in liquid reserves.

Question 3: How specialized is your career path? In addition to considering the possibility of income disruption, it's also wise to consider the possible duration of that loss of income. The more specialized your career path and the higher your income, generally speaking, the longer it will take to replace your job if you lose it. (Do you know a well-educated, high-income person who's been out of a job--or at least underemployed--for a year or longer? Thought so.) Long-tenured workers with more specialized career paths and higher incomes will want to set aside emergency funds equal to a year (or more) of living expenses, while younger workers with less-specialized jobs can get by with a smaller cash cushion closer to three months worth of living expenses.

One mitigating factor is that higher-income workers, especially those with long tenures at their employers, are more likely to receive some type of severance pay than are lower-paid workers with shorter tenures. But there are no guarantees.

Question 4: Are you the sole earner in your household? There's a reason that HelloWallet's Emergency Savings Calculator asks whether you have a partner. If another person in your household is earning an income and contributing to the expenses, that means that you have more of a buffer in case of a job loss than does someone who's the sole earner in his or her household. Thus, your emergency fund needn't be as large as is the case for individuals who are the sole earners in their households.

Sole earners whose employers provide a healthy stipend toward healthcare expenses will want to be especially cautious on the emergency-fund front. Not only would they need to use their emergency fund to cover household expenses if they lost their jobs, but they would also need to accommodate higher outlays for healthcare insurance, deductibles, and so forth.

Question 5: How much wiggle room do you have in your household expenses? Is your budget tilted toward fixed or discretionary expenses? If more than 50% of your income goes toward non-negotiables like your mortgage, car payments, tuition payments and the like, you'll need to maintain a higher allocation to cash holdings than would be the case if your fixed monthly outlays are a smaller share of your budget.

From this standpoint, middle-career workers need to be especially careful. Workers just starting out are less likely to have taken on mortgages and car payments, and may also be more flexible in their lifestyle choices; in case of job loss, they may be willing to find roommates or move in with their parents. Some older workers, meanwhile, may be close to paying off their mortgages. If they purchased their homes a few decades ago, their housing outlays may be lower than is the case for those who have purchased within the past five to 10 years.

Question 6: Can you access cash in other ways? When I talk about an emergency fund, I'm referring to readily accessible cash held in a bank or brokerage account: checking and savings, money market accounts, money market mutual funds, and CDs. But investors might also have access to next-line reserves if they needed them--accounts that they could tap with few taxes and penalties. Roth IRAs, for example, allow for tax- and penalty-free withdrawals of contributions at any time and for any reason. Investors who have been paying out of pocket for healthcare costs from a health savings account, meanwhile, can raid their accounts for non-healthcare-related expenses, provided they've saved receipts for healthcare expenses they've covered with non-HSA assets. (This article discusses this and other HSA "tricks.")

Having access to various loan types, while less reliable, might also reduce the need for true cash holdings. For example, homeowners might maintain home equity lines of credit to stand by in case of emergency expenses. (Of course, they'll likely pay maintenance fees for a line of credit, reducing their attractiveness.) Access to a 401(k) loan, meanwhile, is less of a safety net, in that such loans must typically be paid off within a short window of time if you lose your job.

Question 7: Do you derive peace of mind from holding cash? The aforementioned questions all relate to an investor's emergency-fund needs. But what about cash as a want--to provide peace of mind, for example? As financial-planning guru Michael Kitces explores in this blog post, investors might derive a sense of contentment from holding cash reserves above and beyond what they actually need to hold as an emergency-fund cushion. Of course, cash is earning next to nothing now, so investors shouldn't go overboard with lush cash holdings. But if holding more than the bare minimum of emergency cash provides peace of mind and financial contentment, that's nothing to sneeze at.

Question 8: Are you an opportunistic investor? Also in the category of cash "wants"--rather than needs--opportunistic investors may want to hold cash to take advantage of periodic dips in value in various security types. That seems like a particularly defensible strategy today, given not-cheap equity valuations and still-low bond yields. Investors holding cash with an eye toward scooping up bargains will, however, want to have in mind a disciplined strategy for doing so. Equity investors might look to Morningstar's stock star ratings or price/fair value data to signal buying opportunities, for example. Investors looking to take advantage of market sell-offs could also plan to deploy their cash holdings at predetermined intervals--for example, investing 25% of their cash hoards upon the first 5% decline in the equity market, the next fourth upon the next 5% decline, and so on.