Updated on 09.16.14

I’m Debt Free & I Have An Emergency Fund – What Now?

Trent Hamm

I spoke on IM with an individual a few days ago who has a six month emergency fund (actually post-tax; it is equal to half of his annual salary) and is also debt free. He currently is putting the full amount into his 401(k) and is receiving employee matching, plus he has a fully funded Roth IRA as well. His question to me was, what now?

First of all, this man deserves a major congratulations. He has put himself into a very nice financial situation without being rich (he qualifies for a Roth IRA, after all), and he also has a very secure basis from which to live out his dreams.

In order to help him figure out what to do next, I asked him the following five questions.

How many years are you from retiring? In other words, how long do you plan to be gainfully employed for the purpose of building up your wealth? One can retire and still work a little at something completely enjoyable, of course.

Where do you see yourself in five years? I told him to spell this out in as much detail as possible, because the more details you add to the picture, the clearer the path to that picture becomes.

What is your level of acceptable risk – and what time do you have to follow investments? This is a pretty typical question. He seemed unsure what I meant, so I put it this way: if you had an investment that suddenly lost 10% in value, would you immediately want to sell that investment, or would you be completely comfortable waiting it out? What about 20%? If you can’t stomach any loss at all, then you should keep your money in TIPS or something to that effect; if you can stomach risk, then you can look at stock investments and so forth. Also, if you don’t have much time, you should look at managed or index funds rather than individual investments, which require time and research.

What is the first thing you think about in the morning? I found this to be a powerful exercise for figuring out what was weighing on my mind, because my first thought in the morning is usually related to a major task I need to accomplish that day. This is just a variation, of course, on “what drives you” or “what is your passion.”

What is the first thing you think about in the morning that brings you happiness? Hopefully, it’s that task; if it’s not, then you should move your life focus to that which does bring you happiness when you wake up. I find that this question, when paired with the one before it, indicates whether or not you’re heading down a healthy track in your life – and gives a good indication of what’s derailing you.

So, how did it turn out? Last night, the individual talked about his answers with me and it was pretty clear that he actually got a lot of personal fulfillment and enjoyment out of his current job and that he was fine with substantial risk, but he didn’t have the time or inclination to follow individual investments. Thus, I encouraged him to buy into a low-expense retirement fund with a target date far, far off in the future, like the Vanguard Target Retirement 2050 Fund (VFIFX). This way, it’s managed carefully, but it also includes a very strong dose of risk, which he is fine with right now considering he is far from retirement and doesn’t mind risk.

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  1. Tim says:

    what now should depend on several things.

    1. The maxed out IRA and 401k isn’t necessarily going to get him to his retirement, so how much of more of his earnings need to go into retirement savings? Then apply risk factor and time involved in investment factor towards other investment vehicles towards that goal. retirement is obviously a long term goal. I’m presuming he is single. If not, then has he maxed out spouse’s IRA, too?

    2. What short and mid term goal(s) does he have? Car, kids, house, continued education, surf board? Has he established savings for those goals?

    3. Aside from the 6 month contingency fund he has saved, does he have emergency funds for insurance deductibles, a major auto repair, a major house repair, medical/dental fund over catastrophic limits or things that aren’t covered, and other personalized emergency fund lines? I believe you should keep the income disruption fund separate from emergency fund. Traditional way of thinking about emergency fund only accounts for living expenses, but not real emergencies outside of income disruption. Is 6 months contingency fund really necessary or is it enough? Is he in a high risk occupation that should require a 12 month contingency fund?

    4. What has he done about health and life insurance? If he can afford to lock in, then he should do it now as he has sufficient resources to do so.

  2. Trent Hamm Trent says:

    Tim: yes, the guy is single (fairly obvious, I thought), and thus he does not have to worry about any sort of dependents. Most of the factors you mention are valuable things to consider if you have dependents.

  3. Rebel says:

    Just a question Trent. If the guy is single, does he want to start a family at some point? Or consider that an option? That might give some other ideas to think about. Like a bigger home, vehicles, schools, and such.

    I must say, I like this article. I am not in this place yet myself. But this might be a good thing to think about from time to time.

  4. Wendy and Neil says:

    Dear the Simple Dollar,

    Help! We are very confused about what to do over the next couple of years. Thank you so much for any help.

    Neil and Wendy are 29 years old, and live in Northern Virginia. They are planning a family in about three years time but for now they want to do everything they can to maximize their net worth. They are willing to take on quite a bit of risk and they are also comfortable adjusting their lifestyle if that is necessary (i.e. selling their homes).

    Wendy is a consultant who earns approximately $135,000 per year. Neil is completing his last year of law school and has a job with a large DC law firm lined up for September 2007 that will pay $145,000. He recently received a $10,000 sign-up bonus in March of 2007. Their expected gross income for 2008 will be roughly $300,000 since Neil will likely receive either a raise or a bonus and Wendy will likely receive a raise. Neil is graduating, however, with a large student loan debt of approximately $150,000 that is currently in deferment, so he’s not obligated to make payments until January 2008. The approximate interest rate on these loans is around 7%.

    Neil and Wendy’s net worth currently looks as follows:

    [b]TOTAL ASSETS: $906,464[/b]

    *Cash and Bank Accounts *
    Checking = $2,405
    Emigrant Direct Emergency Fund = $10,203
    Other Cash Accounts = $442

    *Other Assets *
    Rental Property = $200,000
    Primary Residence = $600,000
    Fair Market Value of Car = $16,827
    Art Collection = $1,335

    *Investments *
    Neil’s Vanguard Target Retirement 2045 (rollover IRA) = $10,273
    Wendy’s T.Rowe Price Retirement 2040 (rollover IRA) = $53,301
    Wendy’s T. Rowe Price Retirement 2045 (401(k)) = $10,379
    Virginia’s VEST 529 Plan for expected child #1 = $650
    Virginia’s VEST 529 Plan for expected child #2 = $650

    [b]LIABILITIES = $621,789[/b]

    *Credit Cards*
    Amex Blue Cash Rewards = $366 (paid off each month)
    Chase Perfect Card Rewards Card = $742 (paid off each month)
    Bank of America Credit Card = $13,008 (at 0% set to expire in May 2007)

    *Other Liabilities *
    Rental Property Mortgage = $123,973 (5-1 ARM at 5.63%; resets in 2009)
    Primary Residence Mortgage = $333,700 (5-1 ARM at 4.5%; resets in 2009)
    Neil’s Student Loans = $150,000 (at 7% interest; in deferment until January 2008)

    [b]OVERALL TOTAL = $284,676[/b]

    Neil and Wendy are unsure how to allocate their income over the next couple of years. They have a number of questions:

    (1) Current Investments in Fund of Funds. Neil and Wendy want to move out of their fund of funds and into a portfolio of index funds. They want to do this because they want to invest aggressively and they also want a different type of allocation. Even more importantly, Neil and Wendy both recognize the importance of taxes. To the extent they can’t place all of their investments in tax-deferred accounts they know that they will soon want to carefully place their tax-inefficient investments in tax-deferred accounts and place their tax-efficient investments in taxable accounts. Here’s the portfolio Neil is thinking to house the approximately $63,000 that are currently invested in Neil and Wendy’s rollover IRAs:

    50.0% ($31,500.00) Vanguard Total Stock Market Index (VTSMX)
    5.0% ($3,150.00) Vanguard Small-Cap Value Index (VISVX)
    5.0% ($3,150.00) Vanguard Value Index (VIVAX)
    5.0% ($3,150.00) Vanguard REIT Index (VGSIX)
    15.0% ($9,450.00) Vanguard Total International Stock (VGTSX)
    10.0% ($6,300.00) Vanguard Total Bond Market Index Fund (VBMFX)
    10.0% ($6,300.00) Vanguard Inflation Protected Securities (VIPSX)

    (2) Neil and Wendy have a specific question about the need to create a money market account. Should they also create a money market account in their rollover IRA? What is the value of creating this? Will this act as a staging ground for dollar cost averaging if Neil and Wendy want to ease money into the various other accounts?

    (3) Diversification across spouses. Should Wendy and Neil diversify across spouses? Neil’s rollover IRA only has about $10K in it currently. Should he, perhaps, use his money to invest ONLY in the Vanguard Total International Stock? Then should Wendy invest in everything else with her money? The problem is that they need the entire $63K if they want to diversify into all of the accounts they selected.

    (4) Tax efficient v. Tax inefficient fund placement. When Neil and Wendy start investing outside of tax-defferred accounts, which funds should they place outside of their accounts and which should they place inside there accounts? Tentatively, they think they should place Vanguard Total Stock Market Index outside of their tax-deferred accounts? Is this correct?

    (5) Priority of maxing out 401(k) or Roth 401(k) and IRAs and tax-efficient mutual funds or annuities versus paying off student loans or other liabilities. Neil and Wendy are not sure whether it makes sense to max out their retirement contributions or pay off Neil’s student loans over the course of the next couple of years.

    (6) Their 4 unit multi-unit residential dream. They are contemplating selling their primary residence (and possibly their rental property), and using the gain to purchase a 4 unit building in the district of columbia. They will then live in one of the units and rent out the other three. The great advantages to this will be tax advantages since if Neil and Wendy live there for 2 years they can take advantage of the $500,000 tax exemption even if they renting out 3 of the units. They also will get very nice depreciation write-offs. They worry a bit about the current real estate market in DC, but they understand the fundamentals of real estate investing and know how to buy a property and ensure that they have positive cash flow. They wonder if a better approach might be to sell their investment property and use the proceeds to pay off Neil’s student loans.

    (7) They also wonder whether anyone has had any experience with HSAs and the health care costs of pregnancy. Does it make sense to stick with a PPO during pregnancy or go with the tax-advantaged HSA?

    (8) Finally, what other creative options should Wendy and Neil consider? They feel like they have a lot of moving pieces.

    Phew! Some challenging questions. Who has the best advice?

    [b]Thank you[/b] very much for participating!


    Wendy and Neil

  5. Tim says:

    I think most of what I mentioned is valuable regardless of whether he has kids or not. I only mentioned one line about kids. His overall savings plan is missing in your post. As I wrote, he is better served by deciding what his short, mid and long term goals are. From there, he can further decide what he needs and wants to do with his money.

  6. Tim M says:

    I’m curious why you would recommend a target date fund instead of regular index funds or ETFs? Also, just because he’s comfortable with risk doesn’t mean he should push the limit, right? Especially since he doesn’t want to spend time managing his investments. Perhaps a biotech ETF or energy fund would be good. Also, a strong REIT would bring in a nice return and strong dividends.

    (Note: this is a different Tim) :)

  7. Jamie says:

    I’d like to echo your first comment and say congratulations to this person! I believe that the best thing for him to do now is to spend some time planning more life goals that he can work towards (as other have mentioned above). The fact that the question “What now?” is being asked would lead me to wonder if this person is working towards any specific (non-financial) goals. Remember that one the main reason you manage your finances in a responsible way is so that you can do things that you believe are meaningful and worthwhile. Have you always wanted to be able to play the guitar? Take some lessons. Have you wanted to start your own business on the side? Save for that and do it. Do you want to be closer to your family? Take trips to go visit them.

    This is not to say that the job of managing his personal finances is now done and that he can buy whatever he wants. He should continue to manage his money responsibly. However, it is very easy to fall into the trap of accumulating money for the sake of accumulating money.

  8. Tim says:

    I think Wendy and Neil’s situation could be a separate posting. Just doing a cursory look over, there are some things missing and things they should do first:

    1. determine retirement savings goal. They can’t really decide how much to save and what to save unless they have this figured out. Their budget is missing in the equation as well as their current tax plan.

    2. just a crude calculation indicates that their contingency fund is not sufficient. the two mortgage payments (figuring lapses in rental) and student loan payments alone would consume the $10k they have saved in only two months. this doesn’t leave anything left over for other expenses. Let’s just call this the contingency fund for income disruptions that will cover an X amount of month’s worth of living expenses. coupled with the fact that they have $13k to payoff on their BofA credit card. unless they have the $13k invested somewhere, the $10k in emergency savings is going to dry up quickly.

    3. since they are planning on a family in three years, they should seriously think about contributing to a baby fund. could be laddered cd’s.

    4. do they have an emergency fund for major house repairs in both their primary and rental properties?

    5. How is the car holding up? what about an emergency fund for insurance deductibles as well as major car repair or savings toward a new/used car?

    6. A couple missing pieces: are there mortgages through the same bank? Do their employees offer matching or percentage contribution to 401k? what kind of medical plan do their employees offer? what kind of costs are they looking at in terms of closing, purchasing, moving to, rental lag on a 4-unit in DC? Could they do it within the budget that they’ve figured out? is their rental currently paying for itself?

    7. i think diversifying the rolled over IRA is a good idea. i wouldn’t diversify across spouses; i’d diversify for each spouse, since the numbers will add up the same anyways. I’d look at grouping your investments if you can. If you can qualify for private/premium investment/banking account, then i’d consolidate most assets to qualify. MMA isn’t necessary. If you qualify for private/premium banking, more than likely it will include some sort of MMA. However, MMA are really there for parking money until you are ready to investmet. You can do this in a high yield savings account, though, and earn higher interest.

    8. you’ll have to do a cost analysis on your employer plan versus hsa. hsa is good for infrequent medical visits over a long period of time. this can be for routine baby visits, but for pregancy costs, i wouldn’t go with hsa.

    9. if selling houses to buy the 4-unit, i’d probably use proceeds to pay off student loan and pay a downpayment on the new house. That is if after all the costs, you have anything left to do so. but you may want to wait until the tax exemption and depreciation write-offs come into effect before you pay off the student loan. moving to DC also has the advantage of being a DC resident and being able to pay instate tuition to any university in the country for your kid, which can be factored into your 529 investment plan.

  9. Tim says:

    I’m not sure if i got the question right about putting certain funds outside tax deferred accounts. Is this Roth 401K or regular mutual funds? i think for now, they should keep everything tax deferred until they get a better picture of where they are going retirement-wise, income is settled, a decision on the rental and primary units, and a better overal tax picture. tax liability is going to be rather significant figuring in the two incomes and bonuses now, to mention potential house sales. moreover, without knowing the 401k questions, budget, and retirement goal, you cannot really recommend which is the best option: tax deferred or tax inefficient.

  10. brooke says:

    i like the time machine postings. I have been reading for 2 years now and recognize many of the previous articles. It always takes me back when I see articles I have read and benefited from in the past. I know it is titled time machine for you, the writer, but it is also a time machine for me the reader.I go back two years when I was just beginning my journey out of debt and those articles helped me through. Now, I am one payment away from finishing off 20k in credit card debt. Very cool feature, just thought I’d give a shout out.

  11. kalvindale says:

    This is a wonderful opinion. The things mentioned are unanimous and needs to be appreciated by everyone. I appreciate the concern which is been rose. The things need to be sorted out because it is about the individual but it can be with everyone.
    Debt Free Seattle

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