Why Do Young Lawyers Need an Emergency Fund?
Executive Summary
In order to take advantage of financial opportunities, you must have financial protection. Life is filled with unexpected and sudden financial events. Unfortunately, roughly half of Americans are unprepared for a financial emergency. For many young lawyers who are just beginning their financial lives, a financial emergency can permanently affect their long-term financial outcomes. One of the best first steps a young lawyer can do is to establish an emergency fund. This fund of 3-6 months of essential expenses provides lawyers with a financial buffer to protect them from surprise bills or even losing their job. It also can empower lawyers to take on opportunities they might not be able to pursue without this financial cushion.
Tommy Lawyer has been working at a Big Law firm for the last few years. He is halfway through paying off his student loans. His apartment is expensive, but Tommy manages to find a way to pay for that, his student loans, and his monthly car payments. He has also been contributing to his employer’s 401(k) plan every paycheck. It would appear that he has his financial life in order.
Then one day, Tommy gets called into his boss’s office and is told that he is losing his job. Tommy is in shock.
As he drives home, Tommy realizes he does not have that much money saved up now that he is unemployed. He only has $2,000 in his bank account.
Tommy rushes home and checks his bank balance online. He does some quick mental math and realizes that the $2,000 will not cover his rent, utilities, car payment, food, credit card bill, and student loan payment for more than one month.
Tommy begins applying for some positions he thinks he is suited for but quickly realizes these firms might not hire him. Even if he accepts a job soon, receiving a paycheck in under a month is highly unlikely. Tommy begins to consider other options including, taking a job driving for Uber, not paying some of his expenses, or selling his car to have enough money to cover a few months.
This unfortunate situation is not uncommon in the real world.
Yet Tommy could have done something to protect himself from a financial disaster after losing his job. Tommy could have established and funded an emergency fund.
What is an emergency fund?
Emergencies are urgent, sudden, and serious events or unforeseen changes in circumstances that necessitate immediate action. But lawyers should be aware that an emergency fund is not only for unfortunate situations. Instead, the emergency fund is for the unexpected and urgent events in our life. These can be both positive and unpleasant events.
Uncertainty is one of a few certainties in life.
Do you know what will happen in 10 years, a year, or even tonight? Maybe you have a best guess, but life is full of unexpected events. Possibly, you are planning to be off by 5 pm when a partner sends you an assignment at 4:30 pm. Or maybe you are planning for a quiet night when you get a text from a friend asking if you want to grab drinks.
Sometimes life is filled with unexpected positive events like promotions or great news. Other times life hits you with an unexpected event like a major car repair or losing your job. In life, we need to protect ourselves from unfortunate situations. By doing so, we can benefit from unexpected positive events.
People do not save for emergencies
According to a July 2021 survey, greater than 50% of Americans have less than three months of emergency savings. Roughly 50% of people with less than three months of emergency savings (25% of all Americans) have no emergency savings.
Americans continue to struggle to save for emergencies. Yet emergencies still happen. When an emergency does happen, the consequences can put financial futures at risk.
But lawyers do not have to be part of this statistic.
Lawyers earn a well-deserved high salary. If more lawyers saved some of their paychecks each month and placed them into an emergency fund, they would improve their chances of handling a financial emergency.
Emergencies and their expenses
The emergency fund is a proactive financial buffer against most emergencies lawyers will face over a lifetime. Its purpose is to provide lawyers with enough money to manage a financial emergency. Some examples of emergencies are:
Natural disasters
Losing a job
Major car repair
Medical emergency
Family emergency
When emergencies strike, expenses still need to be paid. Some examples of those expenses are:
Rent/Mortgage payment
Utilities
Groceries
Transportation
Student loans
Insurance
Medication
Pet supplies
Opportunities of an emergency fund
An emergency fund protects you from unexpected expenses, but it can also support lawyers to take on unforeseen opportunities.
Opportunities like moving cities for a new job, starting a firm, and affording an unexpected trip are a few examples of how an emergency fund can also positively impact the life of a lawyer.
While the name of an emergency fund implies that it is for emergencies, it is much more than that. Not only does it protect you when a financial emergency arises, but it allows you to take advantage of opportunities even if an emergency happens too.
Emergency funds create flexibility.
When someone lives paycheck to paycheck, they are limited in what they can do. When unexpected expenses appear, people without an emergency fund have to find a way to cut back on spending. Or they might not pay for the unanticipated amount, which can have other financial consequences.
When you have an emergency fund, you can absorb these unexpected expenses without changing your lifestyle.
Here is another example:
After taxes and saving for retirement, a lawyer has $1,000 to spend this month on things they need or want. On their way home, their car breaks down, and later the mechanic hands them a bill for $700. If they are living paycheck to paycheck, this is not a problem. They still have $300 to spend this month. But then they are invited on a trip with some friends. The trip will cost about $500. The lawyer would have been able to pay for the trip any other month, but unfortunately, they will have to decline because they cannot afford it.
Instead, if they had established an emergency fund, not only could they have paid for their car repair, but they could have also spent some money from the emergency fund to pay for the trip.
In life, having options is the best way to capitalize on opportunities and avoid setbacks. The emergency fund provides you with more financial options than not having one.
Emergency funds cover essential expenses and reduce costs.
If a lawyer loses their job or a medical issue prevents them from working, they are still responsible for paying their bills.
Take student loans as an example. If lawyers privately refinance their student loans, there is typically a clause that accelerates payment of the loan amount if they miss payments. While the monthly student loan payment can be expensive, missing a payment is drastically more expensive. The emergency fund allows lawyers to pay their student loan payments for a few months while figuring out how to proceed.
Another use of the emergency fund is it allows you to self-insure for a longer time than having no emergency fund. When considering the deductible for health insurance, insurance plans with higher deductibles usually have less expensive monthly premiums. It requires an insured person to pay more before the health insurance begins paying too.
Similarly, disability insurance plans with long elimination periods generally have less expensive monthly premiums.
Lawyers who establish and fund emergency funds can more comfortably purchase health insurance with a higher deductible and disability insurance with longer elimination periods because they can self-fund themselves for more time. This opportunity to self-fund for an extended time allows lawyers to absorb financial emergencies and save money through lower monthly insurance premiums.
An emergency fund supports you to take risks.
If lawyers have ever wanted to start a law firm, an emergency fund is critical. Opening a firm requires upfront costs as well as monthly business expenses. Entrepreneurs budget out these costs and estimate the amount of money needed to pay for these expenses until the business breaks even. But what about the personal bills?
Once a business breaks even, it now has enough revenue to cover its expenses. But an owner still cannot take money to pay for their expenses. Otherwise, the business would be losing money again. An emergency fund can help with this.
If a business owner decides it will take six months to break even and 12 months to have enough revenue to begin receiving a paycheck, the business owner doesn’t need a 6-month emergency fund. Instead, the business owner needs a 12-month emergency fund (and maybe even more).
One of the most important principles to know when starting a business is it will cost more than you think. It is common to face unexpected business expenses while building a business. Just a few of these expenses may significantly delay when an owner can take a salary. But a lawyer’s personal life does not stop when they start a business. Therefore owners have to be prepared for unexpected personal expenses too.
The best way for a new business to fail is to run out of money. Many new start-ups can take years, not months, to generate enough revenue to pay for an owner’s expenses. The emergency fund is one way to give a business owner a better chance of succeeding.
How do I set up an emergency fund?
Before starting an emergency fund, lawyers need to accept that the emergency fund is not an investment. It may feel uncomfortable to leave possibly tens of thousands of dollars in a savings account instead of investing those funds. But an emergency fund's purpose is not to make money, its purpose is to protect you.
Some components of an emergency fund are:
Easy to access funds
Funds can be withdrawn or spent in a matter of minutes, not a matter of days
It consists of cash, not investments
It is safe
When an emergency strikes, lawyers may not have time to figure out how to pay for something. A lawyer needs to be able to access their emergency fund any time of day. While having cash stored at home is one way to establish an emergency fund, it will not be helpful if you are out of town and an emergency strikes or if a disaster happens to your home. Ideally, you would always have some cash on hand, but the bulk of the fund should be with a bank that you can access from a computer or mobile device.
The point of an emergency fund is to withdraw or transfer the funds immediately if need be. Investors may know how little interest they receive on their emergency fund account and think they can get better returns in cash equivalent investments. Cash equivalents are investments that can easily be converted into cash and almost always maintain their value. The problem with these is that emergencies can happen at any time. If the markets are closed, and you need to sell these cash equivalents for cash, you will have to wait until markets are open again. The emergency fund's purpose is not to generate investment returns but to protect you. Keeping the funds in cash means you can withdraw or transfer money in minutes and not in hours or days.
Finally, the emergency fund needs to be safe. If all of your money is under a mattress and your house burns down, the emergency fund will burn up too. One of the safest places to deposit your money is an FDIC-insured bank. Funds deposited at these banks are federally protected from theft and bank failure. Meaning even if the bank closes or is robbed, the federal government will reimburse you for the amount deposited if the amount is less than $250,000.
Most emergency funds will not exceed $250,000, so these banks are a safe way to store your money without worrying about losing it. Banks have also developed systems that allow you to easily access your emergency fund quickly using ATMs, checks, or debit cards. Therefore, establishing an emergency fund through a bank is one of the best ways to get started.
How much should I save in an emergency fund?
This answer is unique to everyone. We all have different lifestyles and financial situations. The rule of thumb is to have 3-6 months of essential expenses.
First, what are essential expenses? These are expenses that you cannot cut out or would be hard to reduce in the case of an emergency. These include:
Rent/Mortgage payment
Utilities
Groceries
Transportation
Insurance
Student loans
Medication
Pet Supplies
But only saving for essential expenses is not always enough because even in an emergency, we may feel compelled to spend on some non-essential items. In general, it is always better to have an overfunded emergency fund than an underfunded emergency fund.
This rule of thumb is also not a set rule for people. Some people may be more prone to emergencies or more concerned about being unprepared financially for an emergency. Increasing the emergency fund to 12 months or more of essential expenses is perfectly acceptable. Lawyers should aim to avoid having too little of an emergency fund, not having too large of an emergency fund.
The 3-6 month rule of thumb can change based on the household. If a household has two working spouses, a 3-month emergency fund may be sufficient because if one spouse cannot work or loses a job, the 3-month emergency fund plus the income of the other working spouse can support the household. Likewise, a one-person household or a household where only one spouse works will usually need a larger emergency fund like six months of expenses.
The number of kids in the household will also affect the amount that households need to save. The takeaway is to determine how much you need to pay all of your essential expenses for a few months then save more than that. Having an adequate emergency fund is a critical component of a healthy financial life.
Make the emergency fund a top priority.
One of the best ways to succeed financially is to avoid financial disaster.
While financial advice like “invest enough to get your employer match” is a common rule of thumb, it should not come before the emergency fund.
An example is a lawyer who can either invest $1,000 in their 401(k) and get a match or establish an emergency fund with $1,000. If the following day, they face an unexpected expense of $500, the $1,000 in the 401(k) cannot help them. They would have to withdraw the money, pay a tax penalty, and wait a certain amount of time (days) to get their money. Meanwhile, the $1,000 in the emergency fund could pay the unexpected expense immediately.
Making the emergency fund a top priority allows you to prioritize other financial strategies later in the future.
For lawyers who want to invest and do not want to wait until they have six months of essential expenses, consider only saving into an emergency fund until it has three months of essential expenses, then change the contribution amounts. Until the lawyer reaches six months, contribute 80% of excess income to the emergency fund and 20% to investing. Once the lawyer reaches six months of essential expenses, they can switch it again and contribute 20% to the emergency fund and 80% to investing. This strategy can continue until the emergency fund has an adequate amount of savings.
There is no rule of thumb on the best way to save for an emergency fund, and take advantage of investing now because this decision is unique to everyone. Lawyers should focus first on building up the emergency fund to a certain level of protection, and then they can ease off the savings. Just make sure the emergency fund is the number one priority. You never know when the next unexpected expense will surprise you.
Establishing and funding an emergency fund is a basic component of a good financial plan. Taking steps to reduce the risk of financial ruin empowers individuals to take on both personal and professional opportunities. If you would like to learn more about creating an emergency fund as part of a comprehensive financial plan, you can schedule a complimentary Meet & Confer.
Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.