5 Tips for Bulletproof Liquidity and Financial Readiness
By Michael T. Ryan - October 2015
Unexpected expenses and financial emergencies are unfortunately part of life. As John Lennon once said, "Life is what happens to you while you're busy making other plans." There is also the old proverb, "We make plans and God laughs". Emergency room visits, home repairs, automobile accidents and insurance deductibles are hardly ever envisioned as part of our "plans" and can quickly drain financial resources.
Here are 5 Tips to allow you to weather the inevitable financial storms:
- Emergency Funds - Keep at least 6 months of living expenses on hand, in cash. This means in a checking, savings account or conservative money market funds with daily liquidity. We often recommend to clients in executive level positions to maintain 12 months of living expenses or more in cash since equivalent jobs take longer to replace. Cash-on-hand is the first line of defense and there really is no better substitute. There is an opportunity cost associated with maintaining a meaningful cash balance, however we deem it a reasonable premium to pay for safety.
- Diversify Investment Accounts - Once a healthy emergency fund has been established, we recommend maximizing contributions to tax-advantaged retirement accounts (such as maximum annual contributions of $18,000 for 401k accounts and $5,500 for IRAs). After contributing the maximum to retirement accounts we recommend establishing a taxable brokerage account to hold liquid investments. The investment assets (generally equities, fixed income assets and funds) held in a brokerage account are generally expected to generate returns that will outpace inflation as well as the return received on your cash savings. When needed you can sell brokerage assets penalty-free and you might even be able to harvest tax losses to offset capital gains.
- Asset Liquidity - Ensure that you are not overly concentrated in illiquid assets such as partnership interests, hedge funds, private Real Estate Investment Trusts (REITs) or even micro-cap and other thinly-traded equities . We recommend that illiquid investments be limited to a maximum of 10% of total assets. In addition, be sure that you are not concentrated in any one investment, even if it is liquid, such as company stock from your employer.
- Home Equity Line of Credit (HELOC) - Establishing a HELOC is a great option to allow for short-term flexibility and emergency spending. I am certainly NOT suggesting that you draw on a HELOC for long-term debt or to maintain your lifestyle. The best use for a HELOC is as source of backstop funding in emergency situations where you need very quick access to cash. Otherwise, I would leave the credit line untapped and not touch it.
- Roth IRA - If your income is below IRS income limits , than establish a Roth IRA. Since a Roth IRA is funded with after-tax dollars, even if you are under 59½, you may withdraw the exact amount of your contributions with no penalties. So, in an emergency, "last resort" scenario you can tap your Roth IRA contributions ( but NOT earnings ) without getting hit with additional taxes or penalties. Certainly not ideal, but we are talking about emergency scenarios here.
Employing the tips above should provide individuals and families with many levers to pull in emergency situations. As mentioned earlier, a cash reserve is certainly a top priority and the fist line of defense. However, having access to back-up sources of liquidity provides additional comfort and flexibility when it is needed most.