Budgeting For An Emergency Fund

With a combined income of $225,000 and a nest egg of $330,000, Rick and Amy Mendez, 41 and 43, seem like they are in good financial shape. But a closer look reveals that they’re lacking something crucial: emergency savings.

As a result, when they needed a new roof in 2009, they had to borrow from their 401(k)s. Credit cards got them through other jams, but they’ve run up a $20,000 balance.

“It’s too risky for them to go without a safety net,” says Framingham, Mass., financial planner Cheryl Costa. At minimum, she says, they need to tuck away $25,000, which equals three months’ worth of expenses.

Easier said than done.

‘My biggest money mistake’
“After the bills are paid, the piggy bank is empty,” says Rick, who works as a director of marketing for a medical device firm. (Amy is a customer service liaison.)

About $1,800 a month, pretax, goes to retirement. Preschool and child care for Averi and Alexander, ages 2 and 5, cost $2,300. Mortgages — for their home and two underwater investment properties in Florida — plus payments on 401(k) loans and car loans eat up $4,450.

The Mendezes need help finding room in their budget.

The Solution
1. Slice the budget.

Cutting back on vacations and meals out should save $400 a month.

Also, in the fall Alexander starts kindergarten and Averi goes to preschool, so nanny hours can be halved to save another $1,000 a month.

They should have these funds automatically transferred to a money-market account for emergencies.

2. Turn off the 401(k) — for now.

While Costa rarely tells anyone to stop saving for retirement, she says building a cushion is the Mendezes’ top priority.

By halting contributions, they’ll free up $1,300 more a month.

On top of the other savings, this should get them to $25,000 by early next year. They should set their 401(k)s to re-up then.

3. Tackle the plastic.

By the time their emergency fund is at the baseline, they’ll also have paid off the 401(k) loan, so they’ll be able to funnel about $2,000 a month to the credit cards.

If they also apply Rick’s bonus to the balances, they’ll be debt-free by the end of 2012.

~ Sarah Max ~